Semiconductors

Stay defensive at least until the US midterm election is over. Gridlock is disinflationary in 2023 and hence marginally positive for US equities. But any relief rally will be short-lived as recession risks are very high.

Please note I will be hosting a live webcast on September 29, 2022 at 9:00 AM HKT for the APAC region. I will discuss the global/China/EM macro outlooks and financial market implications. For clients in the Americas and EMEA, we had a webcast on September 28, 2022. You can access the replay via this link. Arthur Budaghyan Executive Summary Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global semiconductor stock prices are still vulnerable to meaningful downside over the next three months. Global semi consumption will contract due to the corresponding waning demand of smartphones, personal computers, and other consumer electronics. Global semi demand in sectors of automobiles and datacenters will continue growing. However, such an increase in demand cannot offset the demand reduction in other sectors. Semiconductor consumption in China has entered a contraction phase.  Semiconductor inventories have swelled. Alongside a sharp upsurge in chip production capacity, this increase in inventories will lead to chip price deflation in the next nine months. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point for semi stocks.  Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will seek to recommend buying semiconductor stocks when a more material decline in semi companies’ profits is priced in their share prices. At the moment, we are downgrading Taiwanese stocks from neutral to underweight relative to the EM equity benchmark but are maintaining an overweight stance on the Korean bourse within an EM equity portfolio.   The global semiconductor equity index is breaking below its technical support (Chart 1). The implication is that these share prices are in an air pocket and investors should not chase a declining market. Based on previous cycles, we expect global semiconductor stocks to bottom late this year or early next year and semi sales to trough in 2023Q2. In the previous five cycles, global semi stocks always bottomed before global semi sales and lead times varied from three-to-six months. Chart 2 shows that Taiwan’s semiconductor new export orders lead global semi sales by about three months, and they continue to point to considerable downside in the global semi-industry. Chart 1Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Chart 2Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead The semiconductor industry has a history of cyclicality. Shortages have been followed by oversupply, which has led to declining prices, revenues, and profits for semi producers. This time is no exception Global Semi Sales: A Cyclical Slump Underway Global semiconductor demand began its downward trajectory in May of this year and will continue to slide in the next three-to-six months. Both the volume and value of China’s semiconductor imports are in a deep contraction and China’s imports from Taiwan have also plummeted (Chart 3). China is the world’s largest consumer of semiconductors, accounting for 35% of global demand. We expect semi sales to remain in contraction in China and to shrink in regions outside China in the next six-to-nine months (Chart 4).  Chart 3China's Semi Imports Plummeted China's Semi Imports Plummeted China's Semi Imports Plummeted Chart 4Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions There are several important reasons for the retrenchment worldwide. First, the lockdowns around the world in 2020 and 2021 generated an unprecedented increase in online activities and a corresponding surge in demand for smartphones/PCs/tablets/game consoles/electronic gadgets. This was the main driving force for the boom in global semiconductor sales from 2020Q3 to 2022Q1. The excessive demand for consumer goods and electronics has run its course and global demand will sag in the next six months. As we have been contending since early this year, global exports are set to contract. Households that bought these goods in the past two years probably will not make new purchases in the near term. In addition, declining real disposable income and rising interest rates will constrain consumer spending. Smartphones, PCs, tablets, home appliances, and other household electronic goods consume about half of global semi output. In addition, rising job uncertainties resulting from China’s dynamic zero-COVID policy and slowing household income growth will curb consumption within China. Here are our takeaways for each segment: Chart 5China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking Mobile phones: Mobile phones are the largest contributor to global semi sales, with a share of 31% as of 2021, based on the data from World Semiconductor Trade Statistics (WSTS). According to the International Data Corporation (IDC), global smartphone shipments are set to decline by 6.5% year-over-year in volume terms in 2022. Smartphone OEMs cut their orders drastically in 2022 because of high inventories and low demand, with no signs of an immediate recovery. China accounts for 67% of global mobile phone production and its mobile phone production has been contracting (Chart 5, top panel).   Traditional PCs and tablets: Based on data from the IDC, global traditional PC1  and tablet shipments are set to decline by 12.8% year-over-year in 2022 and by an additional 2.6% next year in volume terms. Computer production in China, which is the world’s largest computer producer and exporter, also shows massive downsizing (Chart 5, bottom panel).   Home appliances: China is also the largest producer and exporter of air conditioners (ACs), washing machines, refrigerators, and freezers. Except for a slight growth in AC output in response to heatwaves in China and Europe, China’s output of other home appliances will shrink. Globally, these industries accounted for about half of all semiconductor sales in 2021. Given the overconsumption of these goods worldwide over the past two years, we expect a material decline in these sectors in the next six-to-nine months. Second, automobiles, servers, and industrial electronics, which together account for about 30% of global semi sales, will have positive single-digit growth going forward. Yet, such an increase will not be enough to offset the lost demand from the consumer electronic goods sector in the next six-to-nine months.  Chart 6Global Auto Production Will Rise Global Auto Production Will Rise Global Auto Production Will Rise Automotive (accounts for 11% of world chip demand): The chip shortage in this sector has eased only moderately. Auto output levels in major producing countries remain well below their pre-pandemic levels (Chart 6). In light of improved foundry capacity, semiconductor producers will be able to produce automotive chips and reduce lingering shortages. However, for most chips to automakers, there are no supply shortages. Only a small number of categories of automotive chips, such as microcontrollers (MCU) and insulated-gate bipolar transistors (IGBT), are still in tight supply. Given that the total automotive sector only accounted for about 5% of total global semi sales last year, the recovery in global automobile output will contribute only limited growth to global semi sales.   Servers (account for 10% of world chip demand): The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers. Total server demand is comprised of data servers for cloud providers and private enterprises, with the former as the main driving force in recent years.  Data center expansion among cloud service providers will be driven by 5G, automotive, cloud gaming, and high-performance computing. After expanding by 10% last year, the pace of annual growth in global server shipments will likely be more moderate, to about 5%-6% in the next couple of quarters.   Chart 7Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Industrial electronics (account for 9% of world chip demand): The growth rate in semi demand for this sector is falling. The global manufacturing new order-to-inventory ratio has plunged, and global manufacturing production is set to decline for the rest of this year and through to 2023H1 (Chart 7). Nevertheless, given structural tailwinds for industrial electronics, we expect semi demand in this sector to dip to single-digit growth in the near term rather than to contract.  Third, with semiconductor inventories having surged, new orders for chips, and hence their production, will plummet.   The length and intensity of the chip shortage, which started in 2020H2, triggered stockpiling among a broad range of customers, including manufacturers of smartphones and other consumer electronics. Moreover, the recent slowdown in smartphone/PC demand increased the inventory of silicon chips. Chart 8Semiconductor Inventory Overhang Semiconductor Inventory Overhang Semiconductor Inventory Overhang China had also stockpiled semiconductors from 2020Q2 to 2021Q4. With faltering demand, the country will continue its destocking process in the next couple of quarters. Semiconductor inventories in Taiwan and Korea have surged, corroborating the fact that the current cyclical downturn in the global semi sector will be a severe one (Chart 8). Hence, businesses in the semi supply chain will continue to draw upon their inventories rather than increase their semiconductors orders. This will reduce semiconductor demand meaningfully in the coming months. Bottom Line: The cyclical slump in worldwide semiconductor sales has further to go, with the sector’s sale volumes and prices projected to contract in the next six months. Semi producers will experience a substantial decline in their profits. Comparing Cycles Previous cycles may provide insight in the downside of the cyclical slump in global semi sales. In the previous five cycles, global semi sales experienced a contraction, ranging from 7% to 45% (Table 1). In the current cycle, global semi sales still had 7% year-over-year growth in 2022Q2 (Chart 9). Table 1Six Cyclical Downturns In Global Semiconductor Market Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? Chart 9Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices In fact, the current downturn could be deeper than the one between 2018 and 2019 (when sales contracted by 16%) for the following reasons: Sales of both cell phones and PCs will likely dwindle further this time than they did in 2018 to 2019. The pandemic boosted demand for consumer electronics, but this also brought forward future demand. In comparison with 2018, the current cycle might have a longer replacement cycle for mobile phones and PCs. Unlike 2019, global demand for consumer goods will likely contract rather than decelerate. This has ramifications for the duration and magnitude of the semi downturn.   Economic growth, and job and income uncertainties in China are much worse now than they were between 2018 and 2019. These factors will likely lead to a bigger cut in IT spending by both consumers and businesses, resulting in a larger downturn in global semi demand in this cycle. The tech battle between the US and China is more intense than in it was from 2018 to 2019. In mid-2018, the U.S. imposed a 25% tariff on Chinese imports of semiconductor goods, including machines and flat panel displays. China retaliated by imposing its own 25% tariff on U.S. exports of semiconductor goods, such as test equipment. This month, the US imposed new restrictions on NVIDIA and AMD in relation to selling artificial intelligence chips to Chinese customers. The US also plans to curb further its shipments of chipmaking tools to China. These plans will cut China’s imports of high-end semi products, for which producers enjoy high profit margins. In addition, the shortage of these chips will stall the development and sales of many consumer products within China, which will thereby reduce demand for other types of chips needed for consumer products. Chart 10Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Global semi capacity expansion has recently been much stronger in current cycle than it was in the 2016-2018 cycle. This may lead to a bigger supply surplus in this cycle than in the last one. It takes about 18-24 months, on average, to build a new semiconductor fabrication plant. Thus, large capital expenditures by semi producers in 2021-22 entail considerable new supply in 2023-24. According to IC Insights, the annual wafer capacity growth rates were 6.5% in 2020, 8.5% in 2021 and 8.7% in 2022. This compares with 4%-6.5% between 2016 and 2018 (Chart 10). Rapid capacity expansion typically leads to price deflation for chips and is therefore negative for the semi producers’ profitability and their share prices. Are global semi stock prices already pricing bad news? We do not think so. Nearly all major players saw a drop in revenues in the past cycle. In sharp contrast, only Intel’s revenues have dropped so far in the current cycle (Chart 11). Global semi stock prices will continue falling as companies report shrinking sales and earnings in the next couple of quarters. In former cycles when global semi stocks bottomed, investor sentiment – as measured by the net EPS revisions – was more downbeat than it is currently (Chart 12). Chart 11More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract Chart 12Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Bottom Line: The global semiconductor sector’s cyclical slump could be deeper than it was in the 2018-2019 cycle. Hence, shares prices will fall considerably more than they did in late 2018. Ramifications For Taiwanese And Korean Markets Taiwanese and Korean semiconductor stock prices will probably continue to fall in absolute terms. The former recently broke its three-year moving average and the latter its six-year moving average (Chart 13). Chart 13Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Chart 14TSMC: Smartphone And HPC Make 81% Of Revenue Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? For TSMC, the smartphone sector still accounts for 38% of revenues (Chart 14). Hence, a contraction in global smartphone sales in the next six-to-nine months could hurt the company’s top and bottom lines considerably. Meanwhile, the high-performance computing (HPC) sector became the largest contributor of TSMC revenues with a 43% share. A slowdown in data center investment and a decrease in GPU demand due to falling bitcoin prices will also materially affect the company’s profitability. In addition, the US government’s AI chips export restriction policy will decrease NVIDIA and AMD AI sales to China. According to NVIDIA’s news release, approximately US$400 million in potential chip sales to China (including Hong Kong) will likely be subject to this new restriction. AI chips are manufactured by TSMC with its advanced node technology and have a high-profit margin. Hence, the new policy will negatively impact TSMC’s revenues and profits. For Samsung, the memory market is in a free-fall due to plummeting demand (Chart 15). TrendForce expects the average overall DRAM price to drop by 13-18% in 2022Q4 because of high inventories in the supply chain and stagnant demand. The semi shipment-to-inventories ratios for both Taiwan and South Korea nosedived, pointing to lower semi stock prices in these two markets (Chart 16). Chart 15Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Chart 16Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Bottom Line: Both TSMC and Samsung stock prices have more downside over the next three months.  Equity Valuations And Investment Conclusions The global semiconductor stock index in USD terms has tumbled by 45% from its recent peak. Multiples of semiconductor stocks are near their long-term average levels (Chart 17 and 18). These multiples could undershoot as they did in 2018-2019, which means even more downside is ahead. Chart 17Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Chart 18Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Aside from the profit outlook, higher US bond yields are also causing multiple compression for global semiconductor stocks (Chart 19). As to the allocation to semi stocks within an EM equity portfolio, we recommend downgrading Taiwan from a neutral allocation to underweight and reiterate an overweight stance on the KOSPI. The US-China geopolitical confrontation will escalate in the coming years and Taiwan is at the epicenter of this. These are relative calls, that is against the EM benchmark (Chart 20). We remain negative on their absolute performance. Chart 19Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Chart 20Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark   Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We would recommend buying semiconductor stocks after pricing in a more material contraction in semi companies’ revenues and profits. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1     Traditional PCs are comprised of desktops, notebooks and workstations.

Executive Summary Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake House Speaker Nancy Pelosi’s visit to Taiwan reflects one of our emerging views in 2022: the Biden administration’s willingness to take foreign policy risks ahead of the midterm elections. Biden’s foreign policy will continue to be reactive and focused on domestic politics through the midterms. Hence global policy uncertainty and geopolitical risk will remain elevated at least until November 8.  Biden is seeing progress on his legislative agenda. Congress is passing a bill to compete with China while the Democrats are increasingly likely to pass a second reconciliation bill, both as predicted. These developments support our view that President Biden’s approval rating will stabilize and election races will tighten, keeping domestic US policy uncertainty elevated through November. These trends pose a risk to our view that Republicans will take the Senate, but the prevailing macroeconomic and geopolitical environment is still negative for the ruling Democratic Party. We expect legislative gridlock and frozen US fiscal policy in 2023-24. Close Recommendation (Tactical) Initiation Date  Return Long Refinitiv Renewables Vs. S&P 500 Mar 30, 2022 25.4% Long Biotech Vs. Pharmaceuticals Jul 8,  2022 -3.3% Bottom Line: While US and global uncertainty remain high, we will stay long US dollar, long large caps over small caps, and long US Treasuries versus TIPS. But these are tactical trades and are watching closely to see if macroeconomic and geopolitical factors improve later this year. Feature President Biden’s average monthly job approval rating hit its lowest point, 38.5%, in July 2022. However, Biden’s anti-inflation campaign and midterm election tactics are starting to bear fruit: gasoline prices have fallen from a peak of $5 per gallon to $4.2 today, the Democratic Congress is securing some last-minute legislative wins, and women voters are mobilizing to preserve abortion access.  These developments mean that the Democratic Party’s electoral prospects will improve marginally between now and the midterm election, causing Senate and congressional races to tighten – as we have expected. US policy uncertainty will increase. Investors will see a rising risk that Democrats will keep control of the Senate – and conceivably even the House – and hence retain unified control of the executive and legislative branches. This “Blue Sweep” risk will challenge the market consensus, which overwhelmingly (and still correctly) expects congressional gridlock in 2023-24. A continued blue sweep would mean larger tax hikes and social spending, while gridlock would neutralize fiscal policy for the next two years. Investors should fade this inflationary blue sweep risk and continue to plan for disinflationary gridlock. First, our quantitative election models still predict that Democrats will lose control of both House and Senate (Appendix). Second, Biden’s midterm tactics face very significant limitations, particularly emanating from geopolitics – the snake in this report’s title. Pelosi’s Trip To Taiwan Raises Near-Term Market Risks One of Biden’s election tactics is our third key view for 2022: reactive foreign policy. Initially we viewed this reactiveness as “risk-averse” but in May we began to argue that Biden could take risky bets given his collapsing approval ratings. Either way, Biden is using foreign policy as a means of improving his party’s domestic political fortunes. In particular, he is willing to take big risks with China, Russia, Iran, and terrorist groups like Al Qaeda. The template is the 1962 congressional election, when President John F. Kennedy largely defied the midterm election curse by taking a tough stance against Russia in the Cuban Missile Crisis (Chart 1). If Biden achieves a foreign policy victory, then Democrats will benefit. If he instigates a crisis, voters will rally around his administration out of patriotism. Nancy Pelosi’s visit to Taipei is the prominent example of this key view. The trip required full support from the US executive branch and military and was not only the swan song of a single politician. It was one element of the Biden administration’s decision to maintain the Trump administration’s hawkish China policy. Thus while Congress passes the $52 billion Chips and Science Act to enhance US competitiveness in technology and semiconductor manufacturing, Biden is also contemplating tightening export controls on computer chip equipment that China needs to upgrade its industry.1 Biden is reacting to a bipartisan and popular consensus holding that the US needs to take concrete measures to challenge China and protect American industry (Chart 2). This is different from the old norm of rhetorical China-bashing during midterms. Chart 1Biden Provokes Foreign Rivals Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 2Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reactive US foreign policy will continue through November and possibly beyond – including but not limited to China. The US chose to sell long-range weapons to Ukraine and provide intelligence targeting Russian forces, prompting Russia to declare that the US is now “directly” involved in the Ukraine conflict. The US decision to eradicate Al Qaeda leader Ayman Al-Zawahiri also reflects this foreign policy trend. Reactive foreign policy will increase the near-term risk of new negative geopolitical surprises for markets. Note that the 1962 Cuban Missile Crisis analogy is inverted when it comes to the Taiwan Strait. China is willing to take much greater risks than the US in its sphere of influence. The same goes for Russia in Ukraine. If US policy backfires then it may assist the Democrats in the election – but not if Biden suffers a humiliation or if the US economy suffers as a result. Chart 3US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US import prices will continue to rise from Greater China (Chart 3), undermining Biden’s anti-inflation agenda. Supply kinks in the semiconductor industry will become relevant again whenever demand rebounds  (Chart 4). Global energy prices will also remain high as a result of the EU’s oil embargo and Russia’s continued tightening of European natural gas supplies. Chart 4New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers OPEC has decided only to increase oil production by 100,000 barrels per day, despite Biden’s visit to Saudi Arabia cap in hand. We argued that the Saudis would give a token but would largely focus on weakening global demand rather than pumping substantially more oil to help Biden and the Democrats in the election. The Saudis know that Biden is still attempting to negotiate a nuclear deal with Iran that would free up Iranian exports. So the Saudis are not giving much relief, and if Biden fails on Iran, oil supply disruptions will increase. Bottom Line: Price pressures will intensify as a result of the US-China and US-Russia standoffs – and probably also the US-Iran standoff. Hawkish foreign policy is not conducive to reducing inflationary ills. Global policy uncertainty and geopolitical risk will remain high throughout the midterm election season, causing continued volatility for US equities. Abortion Boosts Democratic Election Odds Earlier this year we highlighted that the Supreme Court’s overturning of the 1972 Roe v. Wade decision would lead to a significant mobilization of women voters in favor of the Democratic Party ahead of the midterm election. The first major electoral test since the court’s ruling, a popular referendum in the state of Kansas, produced a surprising result on August 2 that confirms and strengthens this thesis. Kansas is a deeply religious and conservative state where President Trump defeated President Biden by a 15% margin in 2020. The referendum was held during the primary election season, when electoral turnout skews heavily toward conservatives and the elderly. Yet Kansans voted by an 18% margin (59% versus 41%) not to amend the constitution, i.e. not to empower the legislature to tighten regulations on abortion. Voter turnout is not yet reported but likely far higher than in recent non-presidential primary elections. Kansans voted in the direction of  nationwide opinion polling on whether abortion should be accessible in cases where the mother’s health is endangered. They did not vote in accordance with more expansive defenses of abortion, which are less popular (Chart 5). If the red state of Kansas votes this way then other states will see an even more substantial effect, at least when abortion is on the ballot. Chart 5Abortion Will Mitigate Democrats’ Losses Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake The question is how much of this Roe v. Wade effect will carry over to the general congressional elections. The referendum focused exclusively on abortion. Voters did not vote on party lines. Voters never like it when governments try to take away rights or privileges that have previously been granted. But in November the election will center on other topics, including inflation and the economy. And midterm elections almost always penalize the incumbent party. Our quantitative election models imply that Democrats will lose 22 seats in the House and two seats in the Senate, yielding Congress to the Republicans next year (Appendix). Still, women’s turnout presents a risk to our models. Women’s support for the Democratic Party has not improved markedly since the Supreme Court ruling, as we have shown in recent reports (Chart 6). But the polling could pick up again. Women’s turnout could be a significant tailwind in a year of headwinds for the Democrats. Bottom Line: Democrats’ electoral prospects have improved, as we anticipated earlier this year (Chart 7). This trend will continue as a result of the mobilization of women. Republicans are still highly likely to take Congress but our conviction on the Senate is much lower than it is on the House. Chart 6Biden’s And Democrats’ Approval Among Women Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 7Democrats’ Odds Will Improve On Margin Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reconciliation Bill: Still 65% Chance Of Passing Ultimately Democrats’ electoral performance will depend on inflation, the economy, and cyclical dynamics. If inflation falls over the course of the next three months, then Democrats will have a much better chance of stemming midterm losses. That is why President Biden rebranded his slimmed down “Build Back Better” reconciliation bill as the “Inflation Reduction Act.” We maintain our 65% odds that the bill will pass, as we have done all year. There is still at least a 35% chance that Senator Kyrsten Sinema of Arizona could defect from the Democrats, given that she opposed any new tax hikes and the reconciliation bill will impose a 15% minimum tax on corporations. A single absence or defection would topple the budget reconciliation process, which enables Democrats to pass the bill on a simple majority vote. We have always argued that Sinema would ultimately fall in line rather than betraying her party at the last minute before the election. This is even more likely given that moderate-in-chief, Senator Joe Manchin of West Virginia, negotiated and now champions the bill. But some other surprise could still erase the Democrats’ single-seat majority, so we stick with 65% odds. Most notably the bill will succeed because it actually reduces the budget deficit – by an estimated $300 billion over a decade (Table 1). Deficit reduction was the original purpose of lowering the number of votes required to pass a bill under the budget reconciliation process. Now Democrats are using savings generated from new government caps on pharmaceuticals (a popular measure) to fund health and climate subsidies. Given deficit reduction, it is conceivable that a moderate Republican could even vote for the bill. Table 1Democrats’ Inflation Reduction Act (Budget Reconciliation) Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Bottom Line: Democrats are more likely than ever to pass their fiscal 2022 reconciliation bill by the September 30 deadline. The bill will cap some drug prices and reduce the deficit marginally, so it can be packaged as an anti-inflation bill, giving Democrats a legislative win ahead of the midterm. However, its anti-inflationary impact will ultimately be negligible as $300 billion in savings hardly effects the long-term rising trajectory of US budget deficits relative to output. The bill will add to voters’ discretionary income and spur the renewable energy industry. And if it helps the Democrats retain power, then it enables further spending and tax hikes down the road, which would prove inflationary. The reconciliation bill, annual appropriations, and the China competition bill were the remaining bills that we argued would narrowly pass before the US Congress became gridlocked again. So far this view is on track.   Investment Takeaways Companies that paid a high effective corporate tax rate before President Trump’s tax cuts have benefited relative to those that paid a low effective rate. They stood to suffer most if Trump’s tax cuts were repealed. But Democrats were forced to discard their attempt to raise the overall corporate tax rate last year. Instead the minimum corporate rate will rise to 15%, hitting those that paid the lowest effective rate, such as Big Tech companies, relative to high-tax rate sectors such as energy (Chart 8, top panel). Tactically energy may still underperform tech but cyclically energy could outperform and the reconciliation bill would feed into that trend. Similarly, companies that faced high foreign tax risk, because they made good income abroad but paid low foreign tax rates, stand to suffer most from the imposition of a minimum corporate tax rate (Chart 8, bottom panel). Again, Big Tech stands to suffer, although it has already priced a lot of bad news and may not perform poorly in the near term. Chart 8Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Chart 9Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Renewable energy stocks have rallied sharply on the news of the Democrats’ reconciliation bill getting back on track (Chart 9). We are booking a 25.4% gain on this tactical trade and will move to the sidelines for now, although renewable energy remains a secular investment theme. Health stocks, particularly pharmaceuticals, have taken a hit from the new legislation as we expected. However, biotech has not outperformed pharmaceuticals as we expected, so we will close this tactical trade for a loss of 3.3%. The reconciliation bill will cap drug prices for only the most popular generic drugs and does not pose as much of a threat to biotech companies (Chart 10). Biotech should perform well tactically as long bond yields decline – they are also historically undervalued, as noted by Dhaval Joshi of our Counterpoint strategy service. So we will stick to long Biotech versus the broad market. US semiconductors remain in a long bull market and will be in heavy demand once global and US economic activity stabilize. They are also likely to outperform competitors in Greater China that face a high and persistent geopolitical risk premium (Chart 11).  Chart 10Market Responds To Drug Price Caps Market Responds To Drug Price Caps Market Responds To Drug Price Caps Chart 11Market Responds To China Competition Bill Market Responds To China Competition Bill Market Responds To China Competition Bill Tactically we prefer bonds to stocks, US equities to global equities, defensive sectors to cyclicals, large caps to small caps, and growth stocks to value stocks (Chart 12). The US is entering a technical recession, Europe is entering recession, China’s economy is weak, and geopolitical tensions are at extreme highs over Ukraine, Taiwan, and Iran. The US is facing an increasingly uncertain midterm election. These trends prevent us from adding risk in our portfolio in the short term. However, much bad news is priced and we are on the lookout for positive economic surprises and successful diplomatic initiatives to change the investment outlook for 2023. If the US and China recommit to the status quo in the Taiwan Strait, if Russia moves toward ceasefire talks in Ukraine, if the US and Iran rejoin the 2015 nuclear deal, then we will take a much more optimistic attitude. Some political and geopolitical risks could begin to recede in the fourth quarter – although that remains to be seen. And even then, geopolitical risk is rising on a secular basis. Chart 12Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     Alexandra Alper and Karen Freifeld, “U.S. considers crackdown on memory chip makers in China,” Reuters, August 1, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A3US Political Capital Index Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5BPolitical Capital: Household And Business Sentiment Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5CPolitical Capital: The Economy And Markets Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake

Dear Client, On Monday August 8, I will be sending you an abbreviated version of our monthly Chart Pack. Our regular publication will resume on August 15. Kind regards, Irene Tunkel Executive Summary The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector In the following report we continue answering questions from our “Bear Market 2.0” webcast, by reviewing recent US legislative actions, and their effects on semiconductor and energy stocks. Semiconductors Bill: Over the long term, the recently passed CHIPS+ bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Semiconductors Overview: Semis are "growthy" and have surged on the back of falling yields. They are also highly cyclical, and slowing growth will become a headwind to performance. Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. We prefer more stable growth areas of the Technology sector and are overweight Software and Services as opposed to semis stocks. The bill is not enough to "move the needle". What To Do With Energy? The stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As a result, we downgrade the Exploration & Production segment, maintain our overweight in the Equipment & Services, and boost Storage & Transportation from underweight to neutral on the back of the upcoming new pipeline construction. Bottom Line: We remain underweight semis as the one-off boost from the CHIPS+ bill does not counterbalance demand headwinds. When it comes to Energy, the capex upswing will lower the price of oil which warrants an underweight stance in Exploration & Production names. Feature This week investors experienced a deluge of news and data, spanning the Fed rate decision, the Q2-2022 GDP estimate, and earnings reports from some of the largest US corporations, such as Apple, Amazon, and Facebook. To top it off, we had major developments on the legislation front after a multi-month hiatus. Two major bills, the Chips and Science Act of 2022 (aka CHIPS+) and the Inflation Reduction Act of 2022 (an incarnation of Build Back Better), are close to passage, after months and months of dithering. In this report, we will discuss the potential effects of these pieces of legislation on the two equity sectors most affected, Semiconductors and Energy. Since these sectors are also at the epicenter of recent market action, we hope that this report is timely and will help you make the right investment decisions. Sneak Preview: We maintain our underweight on Semiconductors, and downgrade Energy Exploration and Production to an underweight on the back of falling energy prices. Semiconductors: Is It Time To Close The Underweight? When it comes to semis stocks, the current bear market caused a deeper peak-to-trough correction (40%) than at the bottom of the pandemic, implying that, perhaps, much of the bad news was priced in. We have been underweight semis since early January and are up 14% relative to the S&P 500. With the industry bouncing 20% off its June lows, we question whether we have overstayed our welcome and it is time to close this underweight, especially in light of the imminent passage of the CHIPS+ bill. Let’s start by discussing the bill: Designed In The US, Made In Asia In a November 2021 “Semiconductors: Aren’t They Fab?!” Special Report, we highlighted that semiconductor production is divided among chip designers and manufacturers, a so-called “fabless model,” which has grown in prominence as the pace of innovation made it increasingly difficult for firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. The entire semiconductor industry depends on cooperation between two regions: North America, which houses global leaders in designing the most sophisticated chips, and Asia, which is home to companies that have the technology to manufacture them (Charts 1 & 2). As a result, the US share of chip manufacturing has been falling steadily for the past 30 years, from 37% to 10% (Chart 3). Recent, supply chain disruptions and heightening geopolitical tensions have underscored this country’s vulnerability due to outsourcing of chip manufacturing, which led to renewed calls for chip independence and onshoring. Chart 1Chips Are Designed In The US... What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Chart 2...And Manufactured In Asia What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Objective Of The CHIPS+ Bill Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. The bill will provide financial incentives for both US and non-US chip makers to open manufacturing plants in the US while restricting semiconductor companies’ activities “in specific countries that present a national security threat to the United States.” The provision ensures that China, which has also been recently striving for chip independence, will not be a beneficiary of US government funds. The bill also comes with strings attached: It states that it will not allow companies to use any of the funds to buy back stocks or issue dividends. Chart 3The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Cost Of The Bill Preliminary analysis from the Congressional Budget Office assesses that the bill will trigger roughly $79 billion in new spending over the coming decade. The key provision in the bill is the $52.7 billion for chip makers. Of those funds, $39 billion is earmarked to “build, expand, or modernize domestic facilities” for chip-making, while $11 billion is set aside for research and development. Funds will be spread over five years. The bill also adds $24 billion in tax incentives and other provisions for semiconductor manufacturing. In addition, $2 billion is allocated to translate laboratory advances into military and other applications. While $79 billion sounds like a lot of money, we need to keep things in perspective. As Barron’s pointed out: “According to IC Insights, total semiconductor industry capital spending is estimated to grow 24% this year, to $190 billion. Assuming some growth over the next several years, the bill would be a modest single digit percentage of the aggregate spending over the five-year time period.” Therefore, the financial benefits the bill provides are modest. Key Beneficiaries US chip makers with fab facilities, such as Intel (INTC), Micron Technology (MU), and Texas Instruments (TXN) will be the key beneficiaries of the bill as they are offered financial incentives for opening new plants. Foreign companies, such as TSMC, Samsung, and Global Foundries, might also qualify for financial incentives to open chip production facilities in the US. In fact, Intel, TSMC, and Global Foundries have already announced plans to build plants in the US contingent on the bill’s passing. Fabless chip designers, such as Nvidia (NVDA), AMD, and Qualcomm are unlikely to benefit from the package in a major way. Over the long term, the bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Demand For Chips Is Fading While the bill will have some positive effect on chip manufacturing, there is a lurking danger that production is being ramped up globally just at a time when, after prolonged shortages, demand for chips is starting to fade. Historically, this highly cyclical industry has gone through boom and boost cycles every three to four years. During the Q2 earnings call, TSMC Chief Executive Mr. Wei said that the broader industry is dealing with an “inventory correction” that has led customers to cut orders from some of its peers. After two years of pandemic-driven demand, “our expectation is for the excess inventory in the semiconductor supply chain to take a few quarters to rebalance to a healthier level.” This is not surprising. Semiconductors are highly economically sensitive with sales declining in lockstep with slowing global growth (Chart 4), while inventory levels are picking up (Chart 5). Chart 4Sales Are Declining In Lockstep With Slowing Global Growth Sales Are Declining In Lockstep With Slowing Global Growth Sales Are Declining In Lockstep With Slowing Global Growth Chart 5Chip Inventory Levels Are Picking Up Chip Inventory Levels Are Picking Up Chip Inventory Levels Are Picking Up Demand for two of the industry’s key markets, computers and mobile phones, which account for 50% of the overall chip demand, seems to be deteriorating rapidly amid the slowing global economy. Demand for consumer electronics is fading after a pandemic surge of buying, when consumers pulled forward their spending on phones and computers. Most of these items don’t need to be upgraded or replaced for years. COVID-related lockdowns in China, meanwhile, have also weighed on consumer demand. According to IDC, worldwide shipments of personal computers fell 15% in the June quarter from a year earlier, due to “macroeconomic headwinds.” IDC has also lowered its forecast for 2022 expecting computer shipments to retreat by 8.2%. Canalys said global shipments for mobile phones fell 9% year over year, following economic headwinds, sluggish demand, and inventory pile-up. Memory chips represent 28% of the industry, and DRAM accounts represent three-fifths of memory sales. DRAM prices are falling (Chart 6). According to TrendForce, the average contract price for a DRAM, used widely in consumer items ranging from cars to phones to fridges, fell by 10.6% during the second quarter, compared to a year ago, the first such decline in two years. DRAM prices are expected to slide by 21% in Q3-2022. Companies are telling us similar stories: Micron, the No. 3 player in memory, recently issued revenue guidance well below analysts’ estimates. Chief Executive Sanjay Mehrotra warned that “the industry demand environment has weakened,” with PC and smartphone sales declining. Lisa Su, Chief Executive of AMD, expects computer demand to be roughly flat. Nvidia is bracing for a slowdown in the crypto space and game consoles. Intel has reported disappointing results: PC customers are reducing inventory levels at a rate not seen in a decade, Chief Executive Pat Gelsinger said in a call with analysts. PC makers typically reduce inventory levels of chips when they are expecting lower sales. Chart 6DRAM Prices Are Falling DRAM Prices Are Falling DRAM Prices Are Falling Of course, there is significant variability in demand for chips across sectors: While demand for phones and computers is fading, there is still pent-up demand for auto chips, and servers (Chart 7). According to Ms. Su, demand remains hot for chips used in high-performance computers and servers. TSMC, which has Apple and Nvidia among its clients, seconds this notion: Quarterly revenue for high-performance computers, increased 13% from the previous quarter and was greater than the revenue from smartphones, which rose 3%. There are also significant shortages of less-advanced auto chips (Chart 8). In a recent Q2 earnings call, GM reported that it carries 95,000 unfinished cars in its inventory due to the auto chip shortage. According to Mr. Wei of TSMC, the company will continue investing in auto chips, a product that historically it didn’t emphasize as much as its cutting-edge chips, in response to strong demand. Texas Instruments, which reported stellar results, also said that while it saw strength in the auto and industrial segments, demand from the consumer electronics market remained weak in both the second quarter and the current quarter. Chart 7Demand For Servers Is Still Strong Demand For Servers Is Still Strong Demand For Servers Is Still Strong Chart 8More Chips Will Boost Auto Sales More Chips Will Boost Auto Sales More Chips Will Boost Auto Sales Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. Pricing power is also fading. However, there are still areas immune to the downturn, such as chips for servers, high-performance computers, and less advanced auto chips. Valuations and Fundamentals Earnings growth expectations have also come down significantly off their peak, and are currently at 5% for the next 12 months, which indicates negative real growth (Chart 9). Chart 9Earnings Growth Is Slowing Earnings Growth Is Slowing Earnings Growth Is Slowing Chart 10Valuations Are Above Pre-Pandemic Trough Valuations Are Above Pre-Pandemic Trough Valuations Are Above Pre-Pandemic Trough Semi valuations have pulled back from a 33x trailing multiple to 17x over the course of six months, only to bounce back another 3x since June 16, currently trading at 20x multiple. While valuations certainly moderated, they are still above the pre-pandemic trough in 2019 when the global economy was also slowing. The BCA Valuation Indicator, an amalgamation of various valuation metrics, indicates that semiconductors trade at fair value (Chart 10 & Chart 11). The rebound rally was fast and furious; at nearly 20% off market lows, it feels like much of the recovery from severely oversold conditions has run its course. Chart 11Chips Are Moderately Priced, While Investor Position Is Light Chips Are Moderately Priced, While Investor Position Is Light Chips Are Moderately Priced, While Investor Position Is Light Semis Investment Implications Semiconductors are somewhat unique in that they are both cyclical and “growthy” (Chart 12). Since semis are “growthy,” the past six-week rebound may be attributed to falling rates, which have led to multiple expansion of most growth sectors. However, we need to keep in mind that rates have stabilized because of signs of global slowdown, and that the cyclical nature of semis will get in the way of further outperformance. While we also believe that the CHIPS+ bill is a modest tailwind, it is hard to commit to an industry in the early innings of contraction. For investors who would like to top up their allocations to semis, we recommend companies most exposed to demand from industrial sectors (autos, servers, high performance computers), and staying away from companies most exposed to consumer electronics. Much of the performance of companies that have reported so far hinged on their product mix. Chart 12Semis Are Both "Growthy" And Cyclical Semis Are Both "Growthy" And Cyclical Semis Are Both "Growthy" And Cyclical Bottom Line We are reluctant to add to semis after the sector gained nearly 20% in just six weeks. Economic challenges remain – demand for chips is slowing, and the process of clearing inventory build-up may take several quarters. CHIPS+ is a positive but, in our opinion, is not enough to move the needle. We prefer more stable growth areas of the Technology sector and are overweight Software and Services. We also prefer semis most exposed to demand from non-consumer sectors. What To Do With Energy? We are currently equal-weight Energy. More specifically, we are overweight Energy Equipment and Services, equal weight Explorations and Production (we closed an overweight in March, booking a profit of 50%), and underweight Energy Transportation industry groups. With Brent down 18% and GSCI down 15%, and economic growth slowing, it is essential to review what is in store for the sector. Further, the Inflation Reduction Act, which is now on President Biden desk expecting his signature, has quite a few provisions relevant to the sector. Inflation Reduction Act And Its Effects On The Fossil Fuels Industry This bill is a true marvel of political negotiation and gives all parties something to be happy about and something to complain about. While the bill earmarks $370 billion for clean energy spending at the insistence of Senator Manchin (D, WV), the legislative package provides support for traditional sources of energy like oil, gas, and coal. Broadly speaking, the bill is a positive for expanding domestic energy production and supporting its nascent Capex cycle, which we called for in the “Energy: After Seven Lean Years” Special Report. Development of new wells has already picked up over the past few months (Chart 13). Chart 13New Energy CAPEX Cycle New Energy CAPEX Cycle New Energy CAPEX Cycle Here are a few important rules stipulated by the bill, highlighted by the Wall Street Journal: Expanding offshore wind and solar power development on federal land will now require the federal government to offer more access for drilling on federal territory. Under the bill, the Interior Department would be required to offer up at least two million acres of federal land and 60 million acres of offshore acreage to oil and gas producers every year for the next decade. It would be the first-ever required minimum acreage for offshore oil and gas leasing and would significantly increase the acreage requirements for onshore leasing. The bill would also effectively reinstate an 80-million-acre sale of the Gulf of Mexico to the oil drillers last year that a federal judge had invalidated. The bill is also a major positive for the natural gas industry, providing an accelerated timeline for building the pipelines and terminals needed to increase production and export of fossil fuels. In exchange for access to more federal territory, oil and gas companies would also have to pay higher royalty rates for drilling there. It would also require them to pay royalties on methane they burn off or let intentionally escape from their operations on federal lands. The bill aims to increase the supply of oil, gas, and coal, and return the US towards energy independence. Over the medium term, it should lead to a normalization of the price of energy. Demand Vs. Supply Naturally, the price of oil is all about supply and demand. And the performance of the energy sector is inextricably linked to the price of oil (Chart 14). Supply: According to our EM Strategist, Arthur Budaghyan, “fears that sanctions on Russia will considerably reduce global oil supply have not yet materialized.” According to International Energy Agency (IEA) estimates, Russia’s shipments of crude and oil products have declined by only about 5% since January (Chart 15). Clearly, despite the sanctions and logistical challenges that Western governments have enforced on Russia, the country’s oil exports have not collapsed. Chart 14Price Of Oil Is Important For The Energy Sector's Profitability Price Of Oil Is Important For The Energy Sector's Profitability Price Of Oil Is Important For The Energy Sector's Profitability Chart 15Russia's Supply Of Oil Has Decreased By Only 5% Russia's Supply Of Oil Has Decreased By Only 5% Russia's Supply Of Oil Has Decreased By Only 5% Demand: Meanwhile, global commodities and energy demand is downshifting in response to both high fuel prices and weakening global growth. US consumption of gasoline and other motor fuel has marginally contracted (Chart 16, top panel). In China, rolling lockdowns and weak income growth will continue to suppress the nation’s crude oil imports, which have already been depressed over the past 12 months (Chart 16, bottom panel). In the rest of EM (excluding China), a strong dollar and high oil prices are leading to demand destruction. Chart 16US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak Prices Are To Trend Down: Hence, the supply of energy and commodities is stable, but demand is flagging, which does not bode well for the prices of energy and materials. Odds are that oil prices will decline further and recouple with industrial and precious metal prices. In addition, as the market anticipates a turn in inflation, there is a pronounced rotation away from Energy and Materials towards Technology and other growth pockets of the market (Charts 17 & 18). With a supply of energy staying steady or even expanding, while demand is slowing on the back of the global slowdown, we expect the price of energy to trend down. Chart 17Energy And Materials Were Biggest Winners In the "Inflation High And Rising" Regime... What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Chart 18...But They Gave Back Their Gains In "Inflation High But Falling" Regime What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Energy Investment Implications It appears that the stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As production is expanded and prices fall, the profitability of the Oil Exploration and Production industry (upstream) will decline. In addition, inflation is about to turn, and a change in market leadership has already ensued. We downgrade Exploration and Production to an underweight. In the meantime, the Equipment and Services industry will benefit from contracts to develop new wells and will thrive. We maintain an overweight. We are currently underweight the Energy Storage and Transportation industry (mid-stream) as historically, this industry was marred in multiple regulations and most expansion projects faced obstacles, especially if running through public land. However, under the provisions of the Inflation Act, midstream will benefit from rising production volumes and expedited construction the pipelines and terminals needed to increase production and exports of fossil fuels. We upgrade Storage and Transportation to an equal weight. Bottom Line The Inflation Reduction Act will create conditions favorable for expanding the production of fossil fuels and will support US energy independence. As supply grows while demand is slowing, the price of energy is likely to turn – while a boon for US consumers, this is a headwind to the performance of the Energy sector.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Executive Summary Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Global semiconductor stock prices are vulnerable to the downside over the next three to six months. The global semiconductor industry has entered a cyclical slump. Demand for semis faces headwinds this year. The pandemic boom in goods (ex-auto) consumption in developed economies is likely over. Plus, households’ disposable income in these economies is contracting in real terms. In China, ongoing lockdowns are depressing household income, which will limit their discretionary spending. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point.      Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will be looking to recommend buying semiconductor stocks when a more material deceleration in semi companies’ revenue and profits are priced in. Feature Chart 1Semi Stocks Have Been Selling off Despite Strong Revenues Semi Stocks Have Been Selling off Despite Strong Revenues Semi Stocks Have Been Selling off Despite Strong Revenues A small divergence between global semiconductor sales and semi stock prices has opened up (Chart 1). Although global semiconductor sales have been super strong, global semiconductor stock prices peaked in late December and have since declined by 23%. We believe the global semiconductor industry is entering into a cyclical slump. The demand for PCs/tablets/game consoles/electronic gadgets as well as commercial computers and servers – and with them semiconductor sales/shipments – had surged in the last two years.  Behind this boom was the significant increase in online activities stemming from pandemic-related lockdowns. However, these one-off factors have largely run their course. Global semiconductor demand growth currently faces headwinds and is set to slow meaningfully in H2 this year. We expect more downside in global semiconductor stock prices over the next three to six months. The five previous cyclical downturns in the global semiconductor sector resulted in share price declines that were greater than the current 23% drawdown (Table 1). Also, in four of these five cycles, the duration of the peak-to-trough period exceeded the current 3.5 months of decline from the December peak. Nevertheless, the structural outlook for global semiconductor demand remains constructive due to the increasing adoption of the 5G network, electric vehicles, data centers and IoTs. We are waiting for a better entry point later this year. Table 1Key Statistics Of Five Cyclical Downturns In Global Semiconductor Market Global Semi Stocks: More Downside Global Semi Stocks: More Downside Near-Term Demand Headwinds Chart 2Global Semis Sales Have Diverged From Global Manufacturing Cycle Global Semis Sales Have Diverged From Global Manufacturing Cycle Global Semis Sales Have Diverged From Global Manufacturing Cycle There has been a remarkable divergence between world semi sales and the global business cycle (Chart 2). The US ISM manufacturing new order-to-inventory ratio, a barometer of the global business cycle, dropped below 1, signaling a slowdown in US manufacturing in the coming months (Chart 2, top panel). Critically, the volume of China’s semiconductor imports started to contract recently and the growth of Chinese imports from Taiwan also plunged (Chart 3). China is the world’s largest semiconductor consumer, accounting for 35% of global semiconductor demand. The slowdown in the country’s chip demand does not bode well for the global semiconductor market. We expect the growth of semiconductor sales in all regions to decelerate considerably this year (Chart 4). Chart 3China's Semis Import Volumes Are Contracting China's Semis Import Volumes Are Contracting China's Semis Import Volumes Are Contracting Chart 4Semiconductor Sales Value Growth Across Regions Semiconductor Sales Value Growth Across Regions Semiconductor Sales Value Growth Across Regions   First, the one-off boost to demand for goods in general, and electronic devices in particular, due to global pandemic lockdowns has largely run its course. Chart 5The Pandemic Boom In PC Sales Is Largely Over The Pandemic Boom In PC Sales Is Largely Over The Pandemic Boom In PC Sales Is Largely Over Traditional PCs and tablets: Demand for traditional PCs1 and tablets surged in the past two years. This was due to the significant increase in online activities, such as working from home, business, education, e-commerce, gaming and entertainment. According to the International Data Corporation (IDC), after two consecutive years of strong growth, global traditional PC and tablet shipments experienced a 5% contraction in volume terms in 1Q2022. In addition, computer production in China – the world’s largest computer producer and exporter – also showed a significant growth deceleration (Chart 5). These data indicate that the pandemic boom in PC sales is largely over. Server demand: Another major contributor to the boom in semi demand was from the server sector. The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers to run on. However, demand growth for the server sector is also set to decelerate slightly. According to TrendForce Research, global server shipment growth will slow from over 5% year-on-year in 2021 to 4-5% this year. The global server sector and the traditional PC/tablet sectors together account for about 22% of global chip demand, based on the data from the IDC. Second, automobiles and consumer electronic goods (e.g., smartphones and home appliances), – which together account for about 42% of global semiconductor demand – will weaken this year. Both ongoing lockdowns in China and the surge in commodity prices due to the Russia-Ukraine war will exacerbate inflationary pressures and create major headwinds to household disposable income in real terms and discretionary spending around the world. Hence, global consumers will remain cautious in their spending on discretionary goods. For example, China’s household marginal propensity to consume proxy dropped to a 15-year low (Chart 6, top panel). This will translate to constrained household spending this year, leading to weaker sales in consumer electronic goods and automobiles (Chart 6, middle and bottom panel). Similarly, US real household consumption of goods ex-autos is likely to experience a mean reversion this year (Chart 7, top panel). After having bought the sheer number of goods (ex-autos) in the last two years, US consumers are likely to shift their spending towards services. Chart 6China: Consumer Spending Will Continue Disappointing China: Consumer Spending Will Continue Disappointing China: Consumer Spending Will Continue Disappointing ​​​​​​ Chart 7Beware of A Mean-Reversion In US Real Household Consumption Of Goods ex-Autos Beware of A Mean-Reversion In US Real Household Consumption Of Goods ex-Autos Beware of A Mean-Reversion In US Real Household Consumption Of Goods ex-Autos   Plus, very high headline inflation is eroding US consumers' purchasing power (Chart 7, bottom panel). The relapse in DM goods demand will hinder the global semiconductor industry. There are already some signs of a slowdown in consumer demand. Apple was reported to have reduced its orders for its recently released iPhone SE by 20% and cut orders for AirPods by about 10 million units due to weaker-than-expected demand.2 Notably, global smartphone sales have been – and will remain – stagnant due to their longer replacement cycle.3 Chart 8Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Third, inventory stockpiling also contributed to last year’s strong semiconductor sales. The length and intensity of the chip shortage which started in H2 2020 caused a broad range of customers – including the manufacturers of smartphones and other consumer electronics – to order more than they need. This inventory stockpiling caused forward inventory days for customers of semi producers to increase by 28% from last quarter to 50 days, which is near peak inventory levels experienced in the last cycle. Businesses will likely start drawing down their stockpiles, rather than increasing their semiconductors orders this year. This will also reduce semiconductor demand on the margin. The semiconductor shipments-to-inventory ratios from Korea and Taiwan have been falling, corroborating the cyclical downturn in the Asian semi industry (Chart 8). Bottom Line: We believe the global semiconductor sector has entered a cyclical slump. The sector’s sales are facing plenty of headwinds, and its growth will decelerate considerably this year. What About The Supply Shortage? The semiconductor industry has been known for its cyclicality. Periods of shortage have been followed by periods of oversupply. The latter led to declining prices, revenues, and profits for semi producers. Hence, massive expansion plans announced by the major players have indeed raised fears that the supply shortage will turn into a supply glut down the road. The global semiconductor shortage in place since late 2020 has been eased to some extent and is set to diminish considerably later this year and next year. Both a moderation in demand growth and an increase in new capacity will likely mitigate the supply tightness meaningfully. It takes about 18-24 months on average to build a new semiconductor fabrication plan. According to estimates from the Semiconductor Industry Association (SIA), the global semiconductor industry added 4 million wafers per month of manufacturing capacity between January 2020 and January 2022. 75% of this new manufacturing capacity had already come on-line as of October 2021. IC Insights also reported global installed wafer capacity increased 6.7% in 2020 and 8.6% in 2021. It also projected the capacity expansion to be 8.7% in 2022. In comparison, the annual growth rate in global installed wafer capacity was only 3.2% in 2019. Last June, industry organization SEMI estimated that construction on close to 30 new fabs will start by the end of 2022.4 Mainland China and Taiwan added the greatest number of new fabrication plants, followed by the Americas. In addition the world’s top three chip makers (TSMC, Intel and Samsung) all raised their capex plans significantly for this year (Box 1). On the whole, according to IC Insights, worldwide semiconductor capex will likely jump by 24% in 2022 to a new all-time high of $190.4 billion, up 86% from just three years earlier in 2019. BOX 1 Top 3 Chip Makers: Massive Capex Expansion Ahead TSMC doubled capex from nearly US$15bn in 2019 to US$30bn in 2021 and set aside US$40-44bn for 2022, a 33%-47% boost year-on-year. In mid-2021, Samsung’s chip manufacturing unit increased its capex plans until 2030 from US$115bn (about US$12.8 bn annually) to US$151bn (about US$16.8 bn annually), a 31% increase year-on-year. Intel increased its capex from US$14.5 billion in 2020 to $18-19 billion in 2021. This number jumped to US$25-28 billion for 2022, a 39-47% lift year-on-year. In general, massive capex at a collective level will be negative for share prices of semi producers. Announcements of capex expansion, which increase an individual company’s production capacity, could be perceived as a positive for that company. Yet, rapid capacity expansion is typically negative for the overall sector as it often leads to lower prices and profitability down the road. Chart 9Aggressive Collective Capex Ultimately Hurts Semis Stocks Aggressive Collective Capex Ultimately Hurts Semis Stocks Aggressive Collective Capex Ultimately Hurts Semis Stocks Given that the collective capex for the global semiconductor sector has expanded substantially, the odds of an oversupplied semiconductor market have increased. This shift will likely weigh on semiconductor stock prices (Chart 9). Bottom Line: The global semiconductor supply-demand balance is likely improving (demand is slowing and supply is rising). Massive capital spending plans will inevitably raise concerns about an eventual supply glut in the global semiconductor industry. This will weigh on global semiconductor share prices in the coming months. Taiwanese And Korean Semi Stocks Odds are that Taiwanese and Korean semi stock prices will continue falling in absolute terms. Interestingly, since early 2021 TSMC and Samsung share prices have exhibited different price patterns vis-a-vis the global semiconductor stock indexes (Chart 10). TSMC had double tops in the past 15 months and has dropped 30% in USD terms from its January peak despite posting substantial revenue growth (Chart 11, top panel). Chart 10TSMC And Samsung Stock Prices: Do Not Catch A Falling Knife TSMC And Samsung Stock Prices: Do Not Catch A Falling Knife TSMC And Samsung Stock Prices: Do Not Catch A Falling Knife Chart 11Semi Stocks in Asia: Share Prices Lead Corporate Revenues Semi Stocks in Asia: Share Prices Lead Corporate Revenues Semi Stocks in Asia: Share Prices Lead Corporate Revenues Share prices of Korean DRAM producers (Samsung and Hynix) are down over 30% in USD terms from their early 2021 peak, frontrunning the decline in our DRAM revenue proxy (Chart 11, bottom panel). In addition, even though Samsung released better-than-expected business performance for the first quarter last Thursday, it still failed to attract buyers. Both cases –TSMC and Samsung –signal that robust revenue/earnings are no longer enough to trigger a rally in semiconductor share prices. This suggests that the market is forward-looking and foresees a poor outlook. Chart 12Taiwan's New Orders-To-Client Inventories Ratio Suggests The Downturn Is Not Yet Over Taiwan's New Orders-To-Client Inventories Ratio Suggests The Downturn Is Not Yet Over Taiwan's New Orders-To-Client Inventories Ratio Suggests The Downturn Is Not Yet Over A slowdown in demand will lead to a deceleration in both companies’ revenue growth and profits. For TSMC, the smartphone sector still accounts for 44% of the company’s revenue. Hence, a risk is that global smartphone sales contract this year due to longer replacement cycles5 and constrained household spending as inflation curbs their purchasing power. In such a case, TSMC’s sales growth will disappoint, and the stock will likely drop toward $80 (Chart 10 on page 9). Taiwan’s new orders-to-client inventories ratio for semiconductors points to lower semi stocks in this bourse (Chart 12). For Samsung, signs of a slowdown in demand are already emerging in memory chips, reflecting slower sales, primarily of PCs. Moreover, TrendForce expects average overall DRAM pricing to drop by approximately 0-5% in 2Q22 due to marginally higher inventories and weakening demand. Equity Valuations And Investment Conclusions Chart 13Multiples Of Global Semis Stocks Are Still Elevated Multiples Of Global Semis Stocks Are Still Elevated Multiples Of Global Semis Stocks Are Still Elevated The global semiconductor stock index in USD terms has declined by 23% from its recent peak. The still-elevated multiples of semiconductor stocks suggest that there is more downside ahead in absolute terms (Chart 13).  One of the reasons that semi stocks have fallen could be their de-rating amid rising US bond yields. Having rallied tremendously in the past 10 years, global semis had become one of the most expensive industry groups worldwide. As a result, higher US bond yields are causing multiple compression for global semis (Chart 14). The closest comparison for the current episode is probably the 2016-2018 boom-bust cycle (Chart 15). During this period, the massive stimulus in China and the adoption of 4G smartphones/tablets had pushed up semiconductor share prices. In 2018, after the one-off adoption/replacement cycle ran out of steam, semi stocks dropped by nearly 30% amid slowing demand and rising global bond yields. By comparison, the one-off surge in global semi demand in 2020-2021 was much larger than the one in 2016-2018. Also, global semi stocks have rallied by much more and have become more expensive now compared with the 2016-18 episode. We expect a mean reversion in demand to lead to a slightly larger decline in global semi stocks than in 2018. This means that there is still about 15-20% more downside from the current level. As to allocation to semi stocks within an EM equity portfolio, we recommend maintaining a neutral allocation to Taiwan and reiterate an overweight stance on the KOSPI. These are relative calls, i.e., against the EM benchmark. We remain negative on their absolute performance. Chart 14Higher US Bond Yields = Multiple Compression For Global Semis Stocks Higher US Bond Yields = Multiple Compression For Global Semis Stocks Higher US Bond Yields = Multiple Compression For Global Semis Stocks Chart 15A Comparison With The 2016-2018 Semi Rally And Selloff A Comparison With The 2016-2018 Semi Rally And Selloff A Comparison With The 2016-2018 Semi Rally And Selloff Given that Korean stocks in general, and Samsung in particular, have already underperformed, further downside in their relative performance will be limited. As to the Taiwanese overall equity index and TSMC, share prices remain elevated relative to the EM benchmark. Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We will be looking to recommend buying semiconductor stocks after a more material deceleration in semi companies’ revenue and profits gets priced in. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Traditional PCs are comprised of desktops, notebooks and workstations. 2     https://asia.nikkei.com/Spotlight/Supply-Chain/TSMC-says-demand-for-sma… 3     https://www.wsj.com/articles/good-chip-results-wont-be-good-enough-1164… 4     https://asia.nikkei.com/Spotlight/Supply-Chain/Chipmakers-nightmare-Wil… 5     https://www.cnet.com/tech/mobile/getting-a-new-iphone-every-2-years-is-…

Downgrading Semis To An Underweight Downgrading Semis To An Underweight Underweight In the recent Semiconductors: Aren’t They Fab report, we have downgraded the S&P Semis & Semi Equipment index from overweight to neutral on a cyclical basis (3-6 months) on the back of tightening financial conditions that will weigh on the performance of this hypersensitive cyclical industry. So far, the rise in global bond yields has not been fully priced in and remains a headwind (see chart, top panel). Further, semis also face deceleration in manufacturing activity: The ISM New Orders/Inventories ratio has turned sharply down. Historically, it has been a leading indicator for the Global Semiconductor sales, and the relative performance of the industry index (see chart, middle & bottom panels). Last, the sector commands a higher multiple than the S&P 500, while its growth expectations are in line with the market: This suggests that the valuation premium is hardly justified, and there isn’t a valuation cushion to absorb the blow from the global economic slowdown. The combination of these three factors compels us to downgrade semis to underweight. Bottom Line: Today we downgrade the S&P semis & semi equipment index from neutral to underweight. As a reminder, we have recently booked 14% in gains after closing our long semis recommendation (we were overweight Semis from July to December 2021).  

Highlights Industry Deep-dive Report: The Semiconductor and Semiconductor Equipment Industry (“Semis”) has had a fantastic run over the past 12 months. We have been overweight it since June and the trade is ahead of the market by 14%. In this deep-dive report into the sector, we aim to decipher the outlook for 2022. To do so, we review the supply chain, target markets, macroeconomic backdrop, and fundamentals. Production Model: Semiconductor production is divided among IC designers and manufacturers. This separation of design and manufacturing is called the fabless model, which has grown in prominence as the pace of innovation made it increasingly difficult for firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. Designed In The US, Made In Asia: The entire semiconductor industry depends on the cooperation between two regions: North America that houses global leaders in designing the most sophisticated chips, and Asia which is home to companies that have the technology to manufacture them. Geopolitical risks: As a result, the Semis are in the crosshairs of rising tensions between China and the US with both countries seeking chips independence and pushing for onshoring. Conventional end-demand markets span the entire US economy but can be grouped into several main categories. Computing or data processing electronics is one of the largest markets, followed by Communications, Consumer Electronics, and Autos. Growth rates vary across segments. The novel markets for semis came on the back of emerging technologies, such as IoT, 5G, automation, AI, self-driving vehicles, and others, all of which require increasing chip sophistication. These markets present a tremendous long-term opportunity for the industry. Global semis sales grew at 25 percent in 2021. In 2022, market growth is expected to slow to 10 percent. Earnings growth has also been slowing. The industry is not immune to rising costs of raw materials, labor shortages, and supply-chain disruptions. While earnings growth is slowing, operating margins are set to expand over the next 12 months. Valuations are extended: The semis' earnings growth expectations are on par with the S&P 500, but trade with a 14% premium to forward multiple. The macroeconomic backdrop is unfavorable: Tighter monetary policy, slowing economic growth, and a slowdown in China, are headwinds for this hyper-cyclical industry. Investment Outlook: We conclude that we are bullish on the industry on a structural basis but are more ambivalent about its prospects over the next 3-6 months downgrading our portfolio overweight to an equal-weight. Chart 9 Feature Performance The Semiconductors and Semiconductor Equipment industry (“Semis”) has received an unexpected boost during the pandemic: Lockdowns, coupled with helicopter cash drops, have spurred demand for durable goods, and foundries could not work fast enough to produce chips, direly needed by autos, consumer electronics, and computer manufacturers. Since the beginning of the pandemic, Semis have outperformed the S&P 500 by roughly 62%, and the Tech sector by just under 30% (Chart 1). Only this year, Semis are almost 20% ahead of the market (Table 1). This poses a question – can this outperformance continue in 2022, or will the economic growth slowdown and waning demand for goods end this superior run? Chart 1Shortages Boosted Performance Of Semis Shortages Boosted Performance Of Semis Shortages Boosted Performance Of Semis Sneak Preview: While we believe in Semis as a multi-year structural theme, we recommend a tactical equal weight. We have been overweight Semis since June and the trade is ahead of the market by 14.5%. We are closing the overweight on the back of a strong run, rich valuations, slowing earnings growth, and an unfavorable macroeconomic backdrop. Table 1Semis Had A Strong Run Over The Past 12 Months Semiconductors: Aren't They Fab?! Semiconductors: Aren't They Fab?! Semiconductor Primer What Are Semiconductors? I have a confession to make – I have always had only the fuzziest idea of what is inside my computer or under the hood of my car. Well, apparently, it is semis, aka chips, that are the brains of any electronic device that we come across in our daily life. I like the comparison of chips to modern-day bricks, serving a wide range of industries. The American Semiconductor Association (ASA) calls them a “marvel of modern technology,” which they truly are, being a foundation of modern life, packed with up to tens of billions of transistors on a piece of silicon the size of a quarter. Chips power not only our phones and vacuum cleaners, but also innovative medical devices, robots, and wireless internet. Semiconductors make all sectors of the US economy, from farming to manufacturing, more efficient. The number of applications of semis is innumerable, and recent shortages made all of us more aware of these, behind-the-scenes, engines of our daily life. The US Semis Brag Sheet The US semiconductor industry is the worldwide industry leader with about half of the global market share (47%) and sales of $208B in 2020.1 The industry employs over a quarter-million people and supports nearly 1.6 million additional US jobs. Semis are a top-five US export, with more than 80% of industry sales going to overseas customers. The US exported $49B in semiconductors in 2020. Rapid innovation has allowed the industry to produce exponentially more products at a lower cost, a principle known as Moore’s law. How Are Semiconductors Made? R&D is the first step in the production process. Firms involved in semiconductor design develop nanometer-scale integrated circuits that perform the critical tasks that make electronic devices work, such as connectivity to networks, computing, storage, and power management. Chip designers must use highly advanced electronic design automation (EDA) software and reusable architectural building blocks (“IP cores”) to do this task.2 The process requires significant investment: Developing a new chip can cost over 100M dollars and requires many years of work by hundreds of engineers. As chips have become increasingly complex, development costs have rapidly risen. Design is the part of the process that differentiates one type of chips from another and constitutes a competitive moat for the companies that design them. Design is chiefly knowledge- and skill-intensive, accounting for 65% of the total industry R&D and has the highest value-add of the entire production process. Manufacturing is a complex process. Once chips are designed, the process moves to production. Often the chip production starts with processing sand that contains a large amount of silicon. Sand is purified and melted into solid cylinders, that are then sliced into very thin silicon discs, polished to a flawless finish, called “blank wafer.” Wafers are then printed with intricated circuit designs, which are later divided into tiny individual semiconductors, called dies. Dies are later packaged into finished semiconductors that can be embedded into electronic devices. This process is summarized in Chart 2. Chart 2 Cross-Border Supply Chains Types Of Semiconductor Production Companies The chip production process is usually divided between the three types of players that operate in the different segments of the supply chain. IC designing companies or fabless firms focus only on design and outsource fabrication to pure-play foundries and outsourced assembly and test (OSAT) firms. This segment of the value chain is dominated by the US firms such as Qualcomm, Broadcom, Nvidia, and AMD, which account for roughly 60% of all global fabless firm sales (Chart 3). Semiconductor manufacturing companies, aka foundries, receive orders from the IC designing companies and purchase raw materials and equipment to proceed in the chip manufacturing process. TSMC, Global Foundries, and United Microelectronics Corporation (UMC) are some of the largest and are located in Asia. The share of chips manufactured in China, South Korea, Southeast Asia, Taiwan, and other regions in East Asia has soared to 75% (Chart 4). Integrated Device Manufacturers (IDM) cover the entire production process from design to manufacturing. In terms of revenue, Samsung, Intel, and SK Hynix are the world’s three top IDM companies. Recently, there was a global push towards reintegration for geopolitical reasons (more about that later). Chart 3 Chart 4 The fabless model, or separation of chip design and manufacturing, has grown along with the demand for semiconductors since the 1990s, as the pace of innovation made it increasingly difficult for many firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. Since China joined the WTO in late 2001, global manufacturing offshoring switched to a higher gear with the semiconductor industry becoming a poster child for the movement. Except for Intel, which is the only US company that both designs and manufacturers chips, other US corporations completely outsourced their manufacturing to Asia. Designed In The US, Made In Asia As of 2020, the US market share of the global semiconductor market was 47% (Chart 5), dominated by fabless firms. Given the importance of semiconductor design in terms of value-added in the manufacturing process, the US must remain a leader in this stage of production. The US firms spend 17% of sales on R&D, more than any other country, to maintain a competitive edge (Chart 6). And this decisive advantage translates into a disproportionate share of industry revenue. Chart 5 Chart 6 While specializing in chip design creates a competitive moat for the US semi companies, it also makes them vulnerable to supply-chain disruptions: At present only a little over 10% of all chips are manufactured in the US compared to 37% back in the ‘nineties (Chart 7), with the lion’s share of the most sophisticated chips manufactured in Asia. With the separation of design and manufacturing, the US, which is a leader in design, is falling behind as a location for manufacturing technology. As a result, the entire semiconductor industry depends on the cooperation between two regions: North America that houses global leaders in designing the most sophisticated chips, and Asia that is home to companies that have the technology to manufacture the most complex of chips. Both ends (design and manufacturing) of the semiconductor industry also have high barriers to entry due to the technology required to compete in the field, which creates a big problem since major geopolitical players now aim to break down existing supply-chains and to push their corporations towards domestic vertical integration. Chart 7 Supply Chain Fragility The fragility of the semiconductor supply chains was best revealed during the pandemic-induced shutdown. With the global economy coming to a virtual hold, various industries had to cancel their semi orders, and foundries took some of the capacity offline. However, demand for goods rebounded unexpectedly and sharply, jump-started by global fiscal and monetary stimulus. It is important to note that a semiconductor manufacturing plant cannot be simply turned on after a period of inactivity. Not only does it require time to be brought back to life, but also the chip production itself is a month-long process. Semiconductor companies did their best during the lockdown to meet demand and even got an exemption from government-imposed lockdowns as “essential” businesses. The industry managed to increase production to address high demand, shipping more semiconductors every month than ever before by the middle of 2021 (Chart 8). However, chip shortages ensued, because supply, despite its best efforts, could not keep pace with the demand. Expanding semi manufacturing capacity was not an option: Building a fab and bringing it up to full capacity can take anywhere from 24 to 42 months at a price tag of anywhere from $1.7bn to $5.4bn, depending on the quality of the chips manufactured.3 Most industry analysts expect the shortage to linger into 2022.4 Chart 8The Industry Worked Hard To Meet Demand For Chips The Industry Worked Hard To Meet Demand For Chips The Industry Worked Hard To Meet Demand For Chips Geopolitics Semiconductor Industry Is At The Epicenter Of Geopolitical Tensions The semi shortages also came within the broader context of the changing world order and the resulting competition for the key resource. As a result, governments around the globe took action to secure the key commodity for themselves and to establish its production on domestic soil. In the US, once semi-conductor shortages started crippling US manufacturing back in April 2021, President Biden held a semiconductor summit at the White House. In addition, he signed an executive order calling for a 100-day review of the US supply chains. In June, the US Senate passed the bipartisan US Innovation and Competition Act, which includes $52 billion in federal investments for semiconductors (building from the CHIPS for America Act announced in January). The House of Representatives excluded the $52 billion from its version of the bill but most of this semiconductor funding will likely be reinstated in the final compromise version of the bill. We expect the funding to help US-based firms, like Intel, as well as non-US firms, such as Taiwan Semiconductor, which is putting billions of dollars into its next-generation production plant in Arizona. And last, the administration agreed with Japan to cooperate on semiconductor development and supply chains.5 Moving east, the European Commission also expressed its concerns that the Old Continent was naïve to outsource chip manufacturing and now plans to double the EU’s share of global chip production from the current 10% to 20% by 2030 under its new Digital Compass plan which aims to boost “digital sovereignty” by funding various high-tech initiatives. In China, policymakers realized the importance of semis in 2013, and while China will not achieve full self-sufficiency anytime soon, ongoing US sanctions and political pressure will only accelerate the Middle Kingdom’s push for semiconductor supply independence. Already, the new five-year plan that was released this year, prioritizes technological innovation including in the semiconductor space. Japan and South Korea are also devoting state resources to the industry, and global policymakers are seeking ways to reduce dependency on Taiwan due to the risk of conflict over the long run. The broader implication of the global semiconductor production onshoring is two-fold. First, existing supply chains will come under pressure as nations will force their respective semiconductor companies to undergo a complete vertical integration, resulting in much steeper chip prices, unless governments come out with further extravagant subsidies. This transformation also implies higher demand for the output of semiconductor equipment manufacturers as nations are scrambling to build onshore manufacturing facilities. Target Markets Most industries are run on chips, but overall usage can be grouped into several key categories, such as Computers, Communications, Consumer Goods, Autos. These traditional markets account for most of the demand for chips. Conventional Chip Uses Computing aka Data Processing Electronics is one of the largest segments and comprises nearly one-third of all semiconductor usage. This segment represents the demand for chips used for personal computers, servers, and cloud storage. This is one of the fastest-growing categories, which SIA projects to grow at 21% per year6 (Chart 9). While this expected rate of growth is impressive, it is set to slow in the coming year as demand for personal computers is starting to decelerate (Chart 10). On the upside, annual growth in servers continues to rebound, with the year-on-year increase in global server shipments close to 15% (Chart 11). Chart 9 Chart 10Demand For PCs Is Coming Off High Levels... Demand For PCs Is Coming Off High Levels... Demand For PCs Is Coming Off High Levels... Chart 11While Demand For Servers Is On The Rise While Demand For Servers Is On The Rise While Demand For Servers Is On The Rise   Communications Electronics is the second largest chips market. These chips power wireless communications and are getting a boost from the rollout of 5G networks. This segment also benefits from the recently passed US Infrastructure Bill, which has funds earmarked for wireless communication. However, communications chips expect tepid growth of just 1% as the speed of the 5G rollout is disappointing, and many consumers are unwilling to upgrade their phones: Demand for smartphones has only recently turned up (Chart 12). Consumer Electronics is a segment that is expected to contract in the coming year as spending on consumer goods has already exceeded the pre-pandemic trend and has turned down (Chart 13). Chart 12Demand For Smart Phones Has Started To Pick Up Demand For Smart Phones Has Started To Pick Up Demand For Smart Phones Has Started To Pick Up Chart 13Demand For Consumer Goods Is Waning Demand For Consumer Goods Is Waning Demand For Consumer Goods Is Waning   Automotive segment – Modern vehicles are increasingly reliant on chips for advanced brakes, steering systems, fuel efficiency, safety, and other features. So missing chips can easily stall production. While the segment is only 12% of the total, it has gotten the industry’s most negative rap. Auto manufacturers, for example, could experience a $61bn loss in revenue due to supply constraints in 2021.7 However, this segment is expected to grow in the high single digits due to significant pent-up demand for autos (Chart 14). Interestingly, EV makers that deploy the most sophisticated chips were somewhat spared from shortages, which afflicted mostly mainstream chip categories. Chart 14Auto Segment Is Expected To Grow Due To Pent-Up Demand For Cars Auto Segment Is Expected To Grow Due To Pent-Up Demand For Cars Auto Segment Is Expected To Grow Due To Pent-Up Demand For Cars Chips Power The Fourth Industrial Revolution Besides these well-established markets, Semis are also intrinsically a play on every single emerging technology theme. Semiconductors are at the core of disruptive technologies and the fourth industrial revolution. Artificial Intelligence (AI) and Machine Learning (ML) rely heavily on computing power delivered by sophisticated chips to process massive datasets looking for insights. As AI becomes widely deployed in a wide range of industries, demand for powerful chips is bound to soar: The size of the AI chip market is forecast to increase eight-fold from an estimated $10.14bn in 2020 to $83.25bn by 2027.8 Internet of Things (IoT), or interconnectedness of electronics, is another source of demand for chips. However, to realize the full potential of this new-generation technology, processors, modems, and other communication infrastructure must be modernized. 5G adoption is starting to accelerate as new applications are being developed such as the metaverse, immersive gaming, and virtual reality. The higher data rates and lower latencies made possible by 5G are expected to be a driver of demand for advanced semiconductors. In a 2021 KPMG survey, 53% of semiconductor companies believe 5G will become a significant driver of revenue growth in one to two years, and 19% believe it could happen in less than a year.9 Automation: Be it self-driving cars or the installation of manufacturing assembly robots, both require semiconductors. Recent labor shortages and rising wages are another reason automation is to come to the fore: US manufacturers are a case in point, lagging their European and Asian counterparts in new robot installation and in dire need of catching up. While it’s true that automation does not bring an explosive demand shock like IoT and AI do, we would not underestimate the power of that structural force (Chart 15). Chart 15 Fundamentals Sales Growth And Profitability According to the WSTS, the worldwide semiconductor market is expected to show an outstanding growth rate of 25 percent in 2021. The largest growth contributors are Memory with 37.1 percent, followed by Analog with 29.1 percent, and Logic with 26.2 percent. By 2022, the global semiconductor market growth is expected to slow and is projected to grow by 10.1 percent. Americas are expected to grow at 12% next year.10 These forecasts align rather well with bottom-up sales growth forecasts by street analysts at 10.8% (Chart 16), which exceed projected nominal GDP growth of 7.6% and expected sales growth of the S&P 500. This industry continues to be powered by pent-up demand, backlogs of orders, and adoption of brand-new technologies. Earnings growth has recently slowed (Chart 17). Semis is an R&D intense industry, especially for the fabless US companies, which continue to plow funds into research and design of chips to retain a competitive edge. After a pandemic hiatus, the industry now is starting to ramp up its Capex outlays (Chart 18). Chart 16Sales Growth Is To Stay Robust... Sales Growth Is To Stay Robust... Sales Growth Is To Stay Robust... Chart 17But Earnings Growth Is Set To Decelerate But Earnings Growth Is Set To Decelerate But Earnings Growth Is Set To Decelerate Recent labor shortages and rising wages have not bypassed highly educated segments of the labor market, cutting into the profitability of these high-tech labor-intensive businesses. And of course, this industry is not immune to rising costs of raw materials and supply-chain disruptions, albeit less so than many businesses further downstream in the value chain, such as Autos. Chart 18After Pandemic Hiatus, Capex Is On The Way Back After Pandemic Hiatus, Capex Is On The Way Back After Pandemic Hiatus, Capex Is On The Way Back Chart 19Margins Are Expected To Expand Further Margins Are Expected To Expand Further Margins Are Expected To Expand Further Despite all the production challenges, Semis is one of the few industries that are projected to further expand its margins in the coming year (Chart 19). However, just like many other industries, their pricing power is overextended (Chart 20) and is likely to mean revert, constraining companies to pass on higher costs of design, raw materials, and manufacturing to customers. Chart 20Pricing Power Is Extreme And Is Likely To Mean Revert Pricing Power Is Extreme And Is Likely To Mean Revert Pricing Power Is Extreme And Is Likely To Mean Revert Valuations Semis is an industry whose earnings are expected to grow at 8% over the next 12 months, which is on par with the S&P 500. However, Semis are trading at 24x forward earnings, or with a 14% premium to the S&P 500 (21.3x) (Chart 21). Further, earnings growth is decelerating. It is hard to justify this valuation premium, especially in the context of imminent rate hikes. Of course, valuations may reflect the fact that demand for chips is still extremely strong both from conventional markets and nascent technology applications. The industry is also highly profitable, and margins are expected to expand in 2022. To break the tie, we will turn to the analysis of the macroeconomic backdrop in 2022 and whether it is going to be favorable for the industry. Chart 21Valuations Are Overextended Valuations Are Overextended Valuations Are Overextended Macroeconomic Backdrop Semiconductor stocks as a group aren’t just highly sensitive to economic growth, they’re nearly immediately so, sniffing out economic rebounds and downturns before they become evident in broad market data. As a result, investors have to remain on their guard and be very nimble. Subtle shifts in the economic outlook can have a big impact on relative performance. At the moment, several macro trends constitute a headwind for the outperformance of the industry: Global bond yields are expected to rise due to the concerted action of Central Banks, dampening demand for chips, dragging down the sales growth of the Semis, and diminishing future cash flows (Chart 22). The US ISM Manufacturing index has peaked, while the ISM New Orders index is in a downward trend, suggesting an emerging decline in production and diminished demand for chips (Chart 23) Chinese growth is slowing and BCA Research’s house view is that a rebound is not likely until later in 2022. Chart 22Rising Bond Yields Will Be A Headwind For Semis Rising Bond Yields Will Be A Headwind For Semis Rising Bond Yields Will Be A Headwind For Semis Chart 23Decline In The ISM New Orders Signal Less Demand For Semis Decline In The ISM New Orders Signal Less Demand For Semis Decline In The ISM New Orders Signal Less Demand For Semis Therefore, we conclude that, while economic growth is to remain strong in 2022, and will provide a tailwind for many cyclical sectors, semiconductor growth is set to slow, and valuations are likely to compress as a reaction to rising bond yields. The macroeconomic outlook for the industry is contingent upon the direction of the interest rates and is sensitive to economic growth disappointments. In short, the macroeconomic backdrop is unfavorable. Investment Implications The semiconductor industry is positioned at the very core of the global economy. It is one of the key growth engines of the US economy, and one of its top exports. This is an industry highly geared to economic growth and exposed to a variety of emerging technology themes, such as 5G, self-driving vehicles, and the metaverse among many others. It is R&D and Capex intensive and sophisticated. We believe in Semis as a long-term structural theme. Tactically, we are concerned that in 2022 this industry may face macroeconomic headwinds being highly sensitive to slowing growth and rising rates, which are detrimental to the performance of this growth-oriented and cyclical sector. From a fundamental standpoint, sales and earnings growth are slowing and are on par with that of a broad market, yet Semis are trading with a premium to the S&P 500. Tactically, we are neutral on a sector, but structurally we are bullish. We recommend investors with longer holding horizons explore the following ETFs (Table 2), that are designed to capture Semis as an investment theme. Table 2Semis ETFs Semiconductors: Aren't They Fab?! Semiconductors: Aren't They Fab?! Bottom Line In this deep-dive report on the Semiconductor industry, we review the supply chain, the key labor division between fabless chip designers and chips manufacturers, and the issues underpinning a recent push towards onshoring. We explore target markets and look at sales growth rates and fundamentals. We conclude that we are bullish on the industry on a structural basis but are more ambivalent about its prospects over the next 3-6 months downgrading our portfolio overweight to an equal-weight.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Semiconductor Industry Association (SIA) "2021 Industry Facts" May 19, 2021 2     Semiconductor Industry Association (SIA) "2021 STATE OF THE U.S. SEMICONDUCTOR INDUSTRY" 3    Global X "Putting the Chip Shortage into the Context of Long-Term Trends" May 24, 2021 4    Ibid 5    Ibid 6    Ibid 7     Bloomberg, “Chip Shortage: Taiwan, South Korea’s Manufacturing Lead Worries U.S., China” March 3, 2021 8    Ibid 9    Ibid 10   World Semiconductor Trade Statistics "Semiconductor Market Forecast Fall 2021" November 30, 2021   Recommended Allocation

Highlights Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. Unlike in the late 1990s, when rising wages were counterbalanced by robust productivity gains, most of the recent rebound in US productivity growth will prove to be illusory. US inflation will follow a “two steps up, one step down” trajectory. We are currently at the top of those two steps, but rising unit labor costs will eventually drive inflation higher. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted. Such an inversion does not make sense to us. Hence, we are initiating a trade going long the 20-year bond versus the 30-year bond. Go short the 10-year Gilt on any break below 0.85%. UK real bond yields are amongst the lowest in the world. The Bank of England will eventually have to turn more hawkish, which will support the beleaguered pound. Structurally higher bond yields will benefit value stocks. Banks stand to gain from rising bond yields while tech could suffer. The eventual re-emergence of supply-side pressures will catalyze more investment spending. This will bolster industrial stocks. The Supply Side Matters, Again Savings glut, secular stagnation; call it what you will, but for the better part of two decades, the global economy has faced a chronic shortfall of aggregate demand. Times are changing, however. The predominant problem these days is not a lack of spending; it is a lack of production. Unlike during the Global Financial Crisis – when worries about moral hazard complicated efforts to bail out homeowners and banks – the victims of the pandemic elicited sympathy. As a result, governments in developed economies rolled out a slew of measures to support workers and businesses. Thanks to bountiful fiscal transfers, households in the US have accrued $2.2 trillion in income since the start of the pandemic, about $1.2 trillion more than one would have expected based on the pre-pandemic trend (Chart 1). With many services unavailable, consumers diverted spending towards manufactured goods. At first, sellers were able to dip into their inventories to meet rising demand. By early this year, however, inventories had been depleted (Chart 2). Shortages began to pop up across much of the global supply chain. Chart 1Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Chart 2The Pandemic Depleted Inventories The Pandemic Depleted Inventories The Pandemic Depleted Inventories While today’s empty warehouses can be largely attributed to surging demand for goods, supply-side disruptions have also played an important role. Four disruptions stand out: 1) semiconductor shortages; 2) transportation bottlenecks; 3) inadequate energy supplies; and 4) reduced labor force participation. Let us examine all four in turn. Semiconductor Shortages Chart 3Car Prices Have Jumped Car Prices Have Jumped Car Prices Have Jumped The global supply chain was not equipped to handle the dislocations caused by the pandemic. The combination of just-in-time inventory systems and far-flung supplier networks ensured that bottlenecks in one part of the global economy quickly filtered down to other parts of the economy. Few industries are as important as semiconductors. The auto sector has felt the brunt of the chip shortage. Both new and used vehicle prices have soared as dealer lots have emptied out (Chart 3). The drop in vehicle spending alone shaved 2.4 percentage points off US real GDP growth in the third quarter. Semiconductor makers have ramped up production to meet growing demand. The US Census Bureau’s Quarterly Survey of Plant Capacity Utilization showed that semiconductor plants operated an average of 73 hours per week in the first half of this year, up from around 45-to-50 hours prior to the pandemic (Chart 4). Chip production in Northeast Asia has rebounded (Chart 5). Southeast Asian production dropped in August due to Covid lockdowns, with semiconductor exports falling by over a third in Malaysia and Vietnam. Fortunately, since then, a decline in Covid cases and rising vaccination rates have spurred a recovery throughout the region. Chart 4Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chart 5Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Chart 6Memory Chip Prices Are Declining Memory Chip Prices Are Declining Memory Chip Prices Are Declining Commentary from semiconductor companies and automakers suggest that the chip shortage will ease over the coming months. In an auspicious sign, US auto sales jumped to 13.1 million in October from 12.3 million in September. Memory chip prices are also falling (Chart 6). Nevertheless, the overall chip market is unlikely to return to balance until 2023. Transportation Bottlenecks Unlike semiconductors and high-end electronics, which usually arrive by air, bulkier items such as furniture, sporting goods, and housing appliances typically arrive by sea. Port congestion, insufficient warehouse capacity, and a lack of truck chassis on which to place containers have all contributed to transportation bottlenecks. Chart 7Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? As with the semiconductor shortage, we are probably past the worst point in the shipping crisis. Drewry’s composite World Container Index has edged down 11% from its highs, although it is still up more than three-fold from mid-2020 levels (Chart 7). The easing in container shipping costs follows a dramatic 47% decline in the Baltic Dry Index since early October. The number of ships waiting to unload cargo off the coast of Los Angeles and Long Beach remains near record highs (Chart 8). Port congestion should ease over the next few months. US port throughput usually falls starting in the late fall and remains weak during the winter months, bottoming shortly after the Chinese New Year. If throughput remains elevated near current levels this year, this should be enough to clear much of the backlog. Looking further out, shipping costs could face additional downward pressure. Chart 9 shows that the number of container ships on order has risen to a 10-year high; these new ships will be delivered over the next two years. Chart 8Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Chart 9Shipbuilders Are Busy Shipbuilders Are Busy Shipbuilders Are Busy Inadequate Energy Supplies After a torrid rally since the start of the year, energy prices have come off their highs. The price of Brent oil has dipped 6% from its October peak. US natural gas prices have retreated 11%. Natural gas prices in Europe have fallen 37%. Chart 10 The biggest move has been in coal prices, which have dropped 36% over the past two weeks alone. Futures curves are pricing in further declines in key energy prices (Chart 10). BCA’s Commodity and Energy Strategy service expects energy prices to soften over the next 12 months, but not as much as markets are discounting. Their latest forecast calls for the price of Brent crude to average $81/bbl in 2021Q4, $80/bbl in 2022 (versus market expectations of $77/bbl), and $81/bbl in 2023 (versus market expectations of $71/bbl). As we discussed a few weeks ago, years of underinvestment have led to tight supply conditions across the entire energy complex (Chart 11). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Gas reserves followed a similar trajectory, increasing by only 5% between 2010 and 2020 compared to 30% over the prior ten years (Chart 12). Chart 11 Chart 12   With little spare capacity, energy markets have become increasingly vulnerable to shocks. A cold snap across the Northern Hemisphere this spring depleted natural gas supplies, while a lack of wind reduced energy production by European wind farms. Increased gas imports from Russia could have mitigated the problem, but the dispute over the Nord Stream 2 pipeline prevented that from happening. The pipeline is popular with German voters (Chart 13). BCA’s geopolitical team expects it to be approved, a welcome development given that La Niña is highly likely to lead to colder-than-normal temperatures across northern Europe this winter. Chart 13 China has also restarted 170 coal mines and will probably begin re-importing Australian coal. Beijing is also allowing utilities to charge higher prices, which should help stave off bankruptcies across the sector. These measures should help mitigate China’s energy crisis. Chart 14US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels A bit more oil production will also help. The US rig count, while still far below its 2014 highs, has doubled since last year (Chart 14). BCA’s commodity strategists expect output in the Lower 48 states to average 9.5mm b/d in 2022 and 10mm b/d in 2023, versus 2021 production levels of 9.0mm b/d. Nevertheless, shale producers are a lot more disciplined these days. Debt reduction and cash flow generation are now the top priorities. This implies that fairly high oil prices may be necessary to catalyze additional investment in the industry.  Reduced Labor Force Participation Despite the rapid economic recovery, US employment remains 5 million below its pre-pandemic peak. One would not know this from the survey data, however. A record 51% of small businesses expressed difficulty finding qualified workers in the October NFIB survey. The share of households reporting that jobs are plentiful versus hard-to-get has returned to its 2000 highs. Both the quits rate and the job openings rate are well above their pre-pandemic levels (Chart 15). A wave of early retirement accounts for some of the apparent labor market tightness. About 1.3 million more workers have retired since the pandemic began than one would have expected based on demographic trends. Yet, there is more to the story than that. The labor force participation rate for workers aged 25-to-54 has not fully recovered; the employment-to-population ratio for that age cohort is still 2.5 percentage points below pre-pandemic levels (Chart 16). Chart 15 Chart 16Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise   There is considerable uncertainty about how many workers will re-enter the labor force over the coming months. On the one hand, the expiration of enhanced unemployment benefits could prod more workers into the job market. Diminished anxiety about the virus should help. While the number has fallen by half, there are still 2.5 million people not working due to concerns about getting or spreading Covid-19 (Chart 17). According to Boston College’s Center for Retirement Research, the retirement rate rose more for older lower-income workers than higher-income workers (Chart 18). Some of these retirees may decide to re-enter the labor force. Chart 17Less Anxiety About The Coronavirus Should Increase Labor Supply Poorer Older Workers Were More Likely To Retire Last Year Poorer Older Workers Were More Likely To Retire Last Year Chart 18   On the other hand, the imposition of vaccine mandates could reduce labor supply. About 100 million US workers are currently subject to the mandates. According to the Census Household Pulse Survey, about 8 million of them are unvaccinated and attest that “they will definitely not get the vaccine.” Perhaps the biggest question mark is over whether the pandemic will lead to permanent changes in peoples’ perspectives on the optimal work/life balance. High burnout rates (especially in the health care sector), a reluctance to restart the daily commute to the office, and the desire to spend more time with family have all contributed to what some commentators have dubbed The Great Resignation. Ultimately, the deciding factor may be wages. Wage growth accelerated during the late 1990s as the labor market tightened (Chart 19). This drew a lot of people – especially less-skilled workers – into the labor force. Recently, wage growth has exploded at the bottom end of the income distribution, and our guess is that this will entice more people to seek employment (Chart 20). Chart 19Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Chart 20Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly     Will Higher Productivity Growth Mitigate Supply-Side Pressures? The late 1990s saw a resurgence in productivity growth. This helped restrain unit labor costs in the face of rising wages. Chart 21 While US productivity did jump during the pandemic, we are sceptical of claims that this can be attributed to efficiency gains from digitalization and work-from-home practices. A recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. It is telling that productivity outside of the US generally declined during the pandemic (Chart 21). This suggests that last year’s productivity gains stemmed mainly from increased operating leverage, a common feature of post-recession US recoveries (Chart 22). Supporting this view is the fact that productivity growth slowed from 4.3% in Q1 to 2.4% in Q2 on a quarter-over-quarter annualized basis. Productivity declined by 5% in Q3, leading to an 8.3% increase in unit labor costs. Chart 22US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions Chart 23Capital Goods Orders Have Soared Capital Goods Orders Have Soared Capital Goods Orders Have Soared The only saving grace is that core capital goods orders have soared (Chart 23). This should translate into increased business capital spending next year and higher productivity down the road. Investment Implications Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. This is consistent with our “two steps up, one step down” projection for US inflation. We are probably near the top of those two steps at present. This implies that the next move for inflation is to the downside, even if the longer-term trend is still to the upside. The US 10-year Treasury yield should stabilize at around 1.8% in the first half of 2022, before moving higher later in the year. As we discussed last week, markets are understating the true level of the neutral rate of interest. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted (Chart 24). Such an inversion does not make sense to us. Hence, as of this week, we are initiating a trade going long the 20-year bond versus the 30-year bond. We would also go short the 10-year Gilt on any break below 0.85%. The Bank of England’s “surprising hold” knocked the yield down 14 basis points to 0.93%. UK real bond yields are amongst the lowest in the world (Chart 25). Growth is strong and will remain buoyant as Brexit headwinds fade. The BoE will eventually have to turn more hawkish, which will support the beleaguered pound. Chart 24Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Chart 25UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World   Structurally higher bond yields will benefit value stocks. Chart 26 shows that there has been a close correlation between the US 30-year Treasury yield and the relative performance of global value versus growth stocks. Banks stand to gain from rising bond yields while tech could suffer (Chart 27). Chart 26Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Chart 27     The re-emergence of supply-side pressures could affect companies in a variety of unexpected ways. For example, Facebook and Google both rely heavily on revenue from advertising. But what is the point of trying to boost demand for your product if you already cannot produce enough of it? Companies such as Hershey and Kimberly-Clark are already cutting ad spending in response to supply-chain bottlenecks. Finally, tight supply conditions will catalyze more investment spending. This will benefit industrial stocks. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Chart 28 Special Trade Recommendations The Supply Side Strikes Back The Supply Side Strikes Back Current MacroQuant Model Scores Chart 29

Highlights The US government issued its first-ever water-shortage declaration for the Colorado River basin in August, due to historically low water levels at the major reservoirs fed by the river (Chart of the Week). The drought producing the water shortage was connected to climate change by US officials.1 Globally, climate-change remediation efforts – e.g., carbon taxes – likely will create exogenous shocks similar to the oil-price shock of the 1970s. Remedial efforts will compete with redressing chronic underfunding of infrastructure. The US water supply infrastructure, for example, faces an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging plants and equipment, based on an analysis by the American Society of Civil Engineers (ASCE).  This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists. Fluctuating weather and the increasing prevalence of droughts and floods will increase volatility in markets such as agriculture which rely on stable climate and precipitation patterns.We are getting long the FIW ETF at tonight's close. The ETF tracks the performance of equities in the ISE Clean Edge Water Index, which covers firms providing potable water and wastewater treatment technologies and services. This is a strategic recommendation. Feature A decades-long drought in the US Southwest linked by US officials to climate change will result in further water rationing in the region. The drought has reduced total Colorado River system water-storage levels to 40% of capacity – vs. 49% at the same time last year. It has drawn attention to the impact of climate change on daily life, and the acute need for remediation efforts. The US Southwest is a desert. Droughts and low water availability are facts of life in the region. The current drought began in 2012, and is forcing federal, state, and local governments to take unprecedented conservation measures. The first-ever water-shortage declaration by the US Bureau of Reclamation sets in motion remedial measures that will reduce water availability in the Lower Colorado basin starting in October (Map 1). Chart 1Drought Hits Colorado River Especially Hard Drought Hits Colorado River Especially Hard Drought Hits Colorado River Especially Hard Map 1Colorado River Basin Investing In Water Supply Investing In Water Supply The two largest reservoirs in the US – Lake Powell and Lake Meade, part of the massive engineering projects along the Colorado – began in the 1930s and now supply water to 40mm people in the US Southwest. Half of those people get their water from Lake Powell. Emergency rationing began in August, primarily affecting Arizona, but will be extended to the region later in the year. Lake Powell is used to hold run-off from the upper basin of the Colorado River from Colorado, New Mexico, Utah and Wyoming. Water from Powell is sent south to supply the lower-basin states of California, Arizona, and Nevada. Reduced snowpack due to weather shifts caused by climate change has reduced water levels in Powell, while falling soil-moisture levels and higher evaporation rates, contribute to the acceleration of droughts and their persistence down-river. Chart 2Southwests Exceptionally Hard Drought Southwests Exceptionally Hard Drought Southwests Exceptionally Hard Drought Steadily increasing demand for water from agriculture, energy production and human activity brought on by population growth and holiday-makers have made the current drought exceptional (Chart 2). Most of the Southwest has been "abnormally dry or even drier" during 2002-05 and from 2012-20, according to the US EPA. According to data from the National Oceanic and Atmospheric Administration, most of the US Southwest was also warmer than the 1981 – 2010 average temperature during July (Map 2). The Colorado River Compact of 1922 governing the water-sharing rights of the river expires in 2026. Negotiations on the new treaties already have begun, as the seven states in the Colorado basin sort out their rights alongside huge agricultural  interest, native American tribes, Mexico, and fast-growing urban centers like Las Vegas. Map 2Most Of The US Southwest Is Warmer Than Average Investing In Water Supply Investing In Water Supply Global Water Emergency States around the globe are dealing with water crises as a result of climate change. "From Yemen to India, and parts of Central America to the African Sahel, about a quarter of the world's people face extreme water shortages that are fueling conflict, social unrest and migration," according to the World Economic Forum. Droughts, and more generally, changing weather patterns will make agricultural markets more volatile. Food production shortages due to unpredictable weather are compounding lingering pandemic related supply chain disruptions, leading to higher food prices (Chart 3). This could also fuel social unrest and political uncertainty. Floods in China’s Henan province - a key agriculture and pork region - inundated farms. Drought and extreme heat in North America are destroying crops in parts of Canada and the US. While flooding in July damaged Europe’s crops, the continent’s main medium-term risk, will be water scarcity.2  Droughts and extreme weather in Brazil have deep implications for agricultural markets, given the variety and quantity of products it exports. Water scarcity and an unusual succession of polar air masses caused coffee prices to rise earlier this year (Chart 4). The country is suffering from what national government agencies consider the worst drought in nearly a century. According to data from the NASA Earth Observatory, many of the agricultural states in Brazil saw more water evaporate from the ground and plants’ leaves than during normal conditions (Map 3). Chart 3The Pandemic and Changing Weather Patterns Will Keep Food Prices High The Pandemic and Changing Weather Patterns Will Keep Food Prices High The Pandemic and Changing Weather Patterns Will Keep Food Prices High Chart 4Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Map 3Brazil Is Suffering From Its Worst Drought In Nearly A Century Investing In Water Supply Investing In Water Supply Agriculture itself could be part of a longer-term and irreversible problem – i.e. desertification. Irrigation required for modern day farming drains aquifers and leads to soil erosion. According to the EU, nearly a quarter of Spain’s aquifers are exploited, with agricultural states, such as Andalusia consuming 80% of the state’s total water. Irrigation intensive farming, the possibility of higher global temperatures and the increased prevalence of droughts and forest fires are conducive to soil infertility and subsequent desertification. This is a global phenomenon, with the crisis graver still in north Africa, Mozambique and Palestinian regions. Changing weather patterns could also impact the production of non-agricultural goods and services. One such instance is semiconductors, which are used in machines and devices spanning cars to mobile phones. Taiwan, home to the Taiwan Semiconductor Manufacturing Company – the world’s largest contract chipmaker - suffered from a severe drought earlier this year (Chart 5). While the drought did not seriously disrupt chipmaking, in an already tight market, the event did bring the issue of the impact of water shortages on semiconductor manufacturing to the fore. According to Sustainalytics, a typical chipmaking plant uses 2 to 4 million gallons of water per day to clean semiconductors. While wet weather has returned to Taiwan, relying on rainfall and typhoons to satisfy the chipmaking sector’s water needs going forward could lead to volatility in these markets. Chart 5Taiwan Faced Its Worst Drought In History Earlier This Year Investing In Water Supply Investing In Water Supply Climate Change As A Macro Factor The scale of remediating existing environmental damage to the planet and the cost of investing in the technology required to sustain development and growth will be daunting. Unfortunately, there is not a great deal of research looking into how much of a cost households, firms and governments will incur on these fronts. Estimates of the actual price of CO2 – the policy variable most governments and policymakers focus on – range from as little as $1.30/ton to as much as $13/ton, according to the Peterson Institute for International Economics.3 PIIE's Jean Pisani-Ferry estimates the true cost is around $10/ton presently, after accounting for a lack of full reporting on costs and subsidies that reduce carbon costs. The cost of carbon likely will have to increase by an order of magnitude – to $130/ton or more over the next decade – to incentivize the necessary investment in technology required to deal with climate change and to sufficiently induce, via prices, behavioral adaptations by consumers at all levels. The PIIE notes, "… the accelerated pace of climate change and the magnitude of the effort involved in decarbonizing the economy, while at the same time investing in adaptation, the transition to net zero is likely to involve, over a 30-year period, major shifts in growth patterns." These are early days for assessing the costs and global macro effects of decarbonization. However, PIIE notes, these costs can be expected to "include a significant negative supply shock, an investment surge sizable enough to affect the global equilibrium interest rate, large adverse consumer welfare effects, distributional shifts, and substantial pressure on public finances." Much of the investment required to address climate change will be concentrated on commodity markets. Underlying structural issues, such as lack of investment in expanding supplies of metals and hydrocarbons required during the transition to net-zero CO2 emissions, will impart an upward bias to base metals, oil and natural gas prices over the next decade. We remain bullish industrial commodities broadly, as a result. Investment Implications Massive investment in infrastructure will be needed to address emerging water crises around the world. The American Society of Civil Engineers (ASCE) projects an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging water infrastructure in the US alone. This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists.4 At tonight's close we will be getting long the FIW ETF, which is focused on US-based firms providing potable water and wastewater treatment services. This ETF provides direct investment exposure to water remediation efforts and needed infrastructure modernization in the US. We also remain long commodity index exposure – the S&P GSCI and the COMT ETF – as a way to retain exposure to the higher commodity-price volatility that climate change will create in grain and food markets. This volatility will keep the balance of price risks to the upside.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Hurricane Ida shut in ~ 96% of total US Gulf of Mexico (GoM) oil production. Colonial Pipeline, a major refined product artery for the US South and East coast closed a few of its lines due to the hurricane but has restarted operations since then. Since the share of US crude oil from this region has fallen, WTI and RBOB gasoline prices have only marginally increased, despite virtually zero crude oil production from the GoM (Chart 6). Prices are, however, likely to remain volatile, as energy producers in the region check for damage to infrastructure. Power outages and a pause in refining activity in the region will also feed price volatility over the coming weeks. Despite raising the 2022 demand forecast and pressure from the US, OPEC 2.0 stuck to its 400k b/d per month production hike in its meeting on Wednesday.     Base Metals: Bullish A bill to increase the amount of royalties payable by copper miners in Chile was passed in the senate mining committee on Tuesday. As per the bill, taxes will be commensurate with the value of the red metal. If the bill is passed in its current format, it will disincentivize further private mining investments in the nation, warned Diego Hernandez, President of the National Society of Mining (SONAMI). Amid a prolonged drought in Chile during July, the government has outlined a plan for miners to cut water consumption from natural sources by 2050. Increased union bargaining power - due to higher copper prices -, a bill that will increase mining royalties, and environmental regulation, are putting pressure on miners in the world’s largest copper producing nation.   Precious Metals: Bullish Jay Powell’s dovish remarks at the Jackson Hole Symposium were bullish for gold prices. The chairman of the US Central Bank stated the possibility of tapering asset purchases before the end of 2021 but did not provide a timeline. Powell reiterated the absence of a mechanical relationship between tapering and an interest rate hike. Raising interest rates is contingent on factors, such as the prevalence of COVID, inflation and employment levels in the US. The fact that the US economy is not close to reaching the maximum employment level, according to Powell, could keep interest rates lower for longer, supporting gold prices (Chart 7). Ags/Softs: Neutral The USDA crop Progress Report for the week ending August 29th reported 60% of the corn crop was good to excellent quality, marginally down by 2% vs comparable dates in 2020. Soybean crop quality on the other hand was down 11% from a year ago and was recorded at  56%. Chart 6 Investing In Water Supply Investing In Water Supply Chart 7 Weaker Real Rates Bullish For Gold Weaker Real Rates Bullish For Gold     Footnotes 1     Please see Reclamation announces 2022 operating conditions for Lake Powell and Lake Mead; Historic Drought Impacting Entire Colorado River Basin. Released by the US Bureau of Reclamation on August 16, 2021. 2     Please refer to Water stress is the main medium-term climate risk for Europe’s biggest economies, S&P Global, published on August 13, 2021. 3    Please see 21-20 Climate Policy is Macroeconomic Policy, and the Implications Will Be Significant by Jean Pisani-Ferry, which was published in August 2021.  4    Please see The Economic Benefits of Investing in Water Infrastructure, published by the ASCE and The Value of Water Campaign on August 26, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Is The Chip Shortage A Boon or Doom? Is The Chip Shortage A Boon or Doom? Overweight Today we are upgrading the Semiconductor industry group to an overweight. Semis received a lot of bad press this year as chip shortages became a major production bottleneck for a range of industries from autos to gaming computers. Semiconductor manufacturers have reduced their capacity during the pandemic and were struggling to ramp up production to meet pent up demand. This industry is highly cyclical and is a high beta play on the global recovery. The chart on the right illustrates that historically, US Semi earnings have been joined at the hip with the global sales and inventory cycles. Global inventories are at all time lows, and a new restocking cycle is in its infancy. A shortage of chips translates into higher prices and strong earnings growth, which is likely to continue far into the future. Street consensus expects 18% EPS growth over the next 12 months. Further, semis stocks have been in a consolidation mode for the first half of 2021 and have accumulated enough dry powder for a new leg higher. This industry group is trading with a 7% discount to the S&P 500 forward earnings multiple (19.8x vs 21.3x) Importantly, as our BCA colleague, Arthur Budaghyan, observed, semiconductor chip manufacturing is becoming a strategic asset, especially in a standoff between China and the US, and the country that controls the production of semis controls the production of most tech goods. This view highlight structural importance of this investment theme. Bottom Line: We are upgrading the S&P Semiconductors & Semiconductor equipment index to overweight from neutral allocation.